Rising debt levels, primarily for corporations, but also for the public sector, are a market risk to be seriously discussed. The public sector has been accumulating more debt, in the U.S. and elsewhere, as debt-to-GDP levels have risen across most developed countries. The implication is that the ever-increasing cost of servicing the debt becomes a black hole versus what potentially could be more productive uses of budgets and spending elsewhere.
Equally concerning is the rise in corporate debt. Among the multiple debt measures, (they all generally tell the same sobering story), is the rise in long-term debt-to-capital ratio for U.S. companies. The measure shown below is at its highest levels since the 2008 Great Financial Crisis. The debt concern is exacerbated in the context of cash burning companies such as privately held WeWork. However, equally concerning are debt levels for the lower end of investment grade companies (BBB) where leverage is at levels more in line with high yield borrowers than investment grade credits, historically speaking. In short, the mounting debt and longer-term market risk case centers on rising debt levels, too much leverage and world central banks flooding the system with too much money and creating low and in some cases, negative interest rates. The eventual outcome, albeit with uncertain timing, could be very problematic for the economy and the equity and credit markets.
Large-Capitalization U.S. Stocks* Long Term Debt-to-Capital Ratios
Eleven years of extraordinary monetary stimulation has propelled financial assets measurably higher than the commensurate change in nominal GDP growth. Approximately $12.4 trillion in world interest rates are at negative yields, including mortgages in some countries and even some high yield debt. Money and credit are historically easy at very low, even negative borrowing costs, providing a potentially distorted environment for capital allocators and investors.
Up to this point, higher debt levels have been problematic primarily in more isolated cases rather than on a systemic basis. To be fair, in aggregate companies continue to generate sufficient cash flow to service their debt levels and an important debt servicing metric such as EBITDA margins for the S&P 500 remain at peak levels of 20%. Corporate debt ratios, such as their earnings before interest (EBIT-to-interest expense) remain very low, thanks to the low cost of borrowing. Indeed, interest paid on existing and new fixed rate debt has declined by 2 percentage points and the average rate is about 4%. In this environment, many companies have been sensible capital allocators, using their cash flow to not only service debt, but to increase dividends, buy back shares, spend on capital or look for acquisitions.
Large-Capitalization U.S. Stocks* EBIT-to-Interest Coverage Ratios
One area of potential concern, if debt service ratios weakened, would be private equity where buyouts are done at ever-higher multiples and financed with private credit funds, which use leverage to generate higher returns. Here we are closely monitoring the combination of deals done at high valuations, financed with higher debt levels, by players who too often were not in the game before or during the great financial crisis. For investors buying this debt we are reminded that yield does not necessarily equal total return and that higher potential return comes with higher risk.
For the time being, low interest rates have been a key force for a sustained business expansion and a rise in financial assets. What to be cognizant of, especially if this occurs in the later innings of a business cycle, is when the allure of low borrowing costs leads to excess use of debt and results in too much leverage. Low borrowing costs can help the eventual return on invested capital if borrowers act judiciously in their capital allocation decisions. We liken capital discipline, in a low interest rate world specifically, to the concept of free beer. When free, perhaps the first two or three beers would yield a good outcome. Increase that free beer count to maybe five or six, and the impact is likely to yield a different outcome. In the meantime, we will be even more vigilant on monitoring higher debts levels and the potential risk to markets and investor capital.