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As US corporate leverage soars, is history repeating?

As US corporate leverage soars, is history repeating?

Debt levels continued to climb among US corporates last year even as a tightening cycle gathered momentum, leaving many uneasy about how businesses will handle rollover risk if rates take off. 

A January spike in pay, as a series of states increased their minimum wages, on top of galvanised bond market unease last week, drove the benchmark 10-year Treasury yield from 2.6% to above 2.8%.

Concerns on leverage are increasingly dictating equity valuations according to Bloomberg, with the spread of returns between the least and most indebted stocks last year at its highest since 2014.

Non-financial corporate leverage in the US is at its highest level since before 2008 relative to gross domestic product (GDP), with data showing US corporate debt among non-financials stands at $8.7 trillion (£6.2 trillion), or more than 45% of GDP.

It’s something concerning Allianz Global Investors’ fixed income manager Mike Riddell, who said: ‘We’ve seen these big run-ups in leverage before, ahead of the early 1990s recession, the dotcom bubble, and ahead of the financial crisis in 2008. And it’s not going into building new factories, it’s going to equity holders. There could be a recession on the horizon, but it is specifically a US problem.’

For Ben Edwards, who co-manages BlackRock’s Corporate Bond and Sterling Strategic Bond funds, the scale of leverage is not the issue, but rather shows the problem when the ‘catalyst arrives’.

He said: ‘Yes companies now may have more debt, but they’re paying less on that debt. US corporates are also able to borrow for longer, and that visibility locks down funding costs as it shows them what the repayments will be.

‘The level of debt wasn’t necessarily the catalyst in 2008; it’s more that it tells you how bad the problem will be when the catalyst arrives.’

Riddell warned the market ‘isn’t prepared’ for a rise in inflation and wage growth rates in the US, and believes an unexpected rate hike could be the catalyst to a sharp shock: ‘If the [Federal Reserve] has to hike rates more than the market is pricing in, you can clearly see the path to pain.’

‘Aversion to highly leveraged companies’

Edwards believes the recent US tax reform could also have an impact, helping investment grade bonds but hitting high yield companies hard.

Research from Deutsche Bank shows a majority of CCC companies in the US have an interest expense of over 58% of earnings before interest, taxes, depreciation and amortisation (Ebitda), while most BB and B rated issuers do not, meaning ‘highly-levered CCC companies could experience a larger wave of defaults than previously expected prior to the new tax plan.’

Proposals within the tax plan to repatriate overseas corporate cash holdings are also something concerning Edwards, but he said it’s a company specific problem: ‘A good example is two telecom companies. One has said the ability to repatriate US cash means it allow it to deleverage and pay down some of its debt.

‘But then one of its competitors has done the opposite and said it will allow it to leverage. These are the companies we want to avoid.’

A fund manager survey from November by Bank of America Merrill Lynch showed a record 23% of equity investors believe US corporate balance sheets are over-leveraged.

A research note towards the end of last year from strategists at Société Générale said ‘aversion to highly leveraged companies is increasingly visible’, adding: ‘Over the last few weeks the beta of bad balance to good balance sheet companies has been negative.

‘To put it more simply, one group has been going up whilst the other has been going down.’

But Mike Corcell, manager of the RWC US Absolute Alpha fund, is less alarmed. He admitted the credit markets would be a concern, but only if the US economy wasn’t performing so strongly.

He said: ‘[Corporate leverage] is not something I’m worried about right now. There’s a huge incentive to go out and spend. Companies are bringing factories back into the US, unemployment is the lowest it has been in a decade, factory orders are up 40%, capex spending is up 30%.

‘Maybe other fund managers are seeing something I’m not seeing. There’s normally a slowdown in winter but we didn’t even see that this year.’

Like Riddell he does see interest rates as a concern, but believes it’s more of a global issue: ‘The key worry right now is interest rates globally. If we were wrong it would be dramatic. That’s the key concern right now, if interest rates go up dramatically.

‘A very damaging scenario is if rates rise but the economy doesn’t go up. But at the moment our view is that the economy can withstand the interest rate increases.’

Despite the concern, Edwards said deleveraging is not something that’s currently high up on companies’ priority lists.

He said: ‘Ultimately it’s about incentives. CEOs are hired and fired by shareholders.

‘They come first, and then nominally it is employees through wage increases, for example Walmart, who’ve announced a wage rise for their employees.

‘Companies do that because they get nice headlines, and a pat on the back from [US president] Donald Trump. Only after that is solidifying the balance sheet a priority.’  

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