Six Striking Observations About Corporate Debt

Here are a handful of striking observations on the real problem with the global debt bubble, courtsy of CLSA's Damien Kestel, and why any spike in interest rates could lead to a global fiasco.

Extraordinary low interest rates around the world have delivered a monumental blow to many investors. Falling interest rates have translated into rising liabilities for (defined benefit) pension plans and, secondly, millions of retirees, who depend on income from savings to take them through retirement, are struggling to make a decent living.

 

Consequently, investors take risks that they weren't previously prepared to take, some of which I am comfortable with, and some of which I am not. Take US corporate high yield bonds. The prevailing view seems to be that US corporates (ex. energy) are in very good shape with loads of cash on their balance sheet, and that they therefore offer a relatively attractive, and a comparatively safe, investment opportunity.

 

I beg to disagree. Firstly, we are late in the economic cycle, and it is usually a bad idea to buy corporate high yield bonds late in an economic upturn. Secondly, let me share some facts with you that undermine the perception outlined above:

  1. The 1% most cash-rich of all US companies control over 50% of all US corporate cash.
  2. The five most cash-rich US companies (Apple, Microsoft, Google, Cisco and Oracle) control 30% of all US corporate cash.
  3. Total US corporate debt (the other side of the balance sheet) was $5.03 trillion at the end of 2015- up from $2.62 trillion at the end of 2007.
  4. Net debt (i.e. debt ex. cash) amongst US corporates was $3.39 trillion at the end of 2015 vs. $1.88 trillion at the :nd of 2007.
  5. US corporate debt has risen by $2.8 trillion over the last five years, while corporate cash has only risen by $600 billion.
  6. If you back out the top 1% referre~ to in (1) above, the cash holdings of the remaining 99% fell 6% in 2015 to stand at just $900 billion by the end of December vs. $6.6 trillion of debt.


Based on those numbers, I think it is fair to say that, with the exception of a few extremely cash-rich companies, corporate America is increasingly indebted and not at all as cash-rich as widely perceived.  This also explains why corporate investments in the US are at a 60-year low.

 

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And then, even thought we've covered it before, there's this:

Governments globally are persisting with monetary expansion to support economic growth and prop up inflation, to the detriment of credit quality, particularly for over-indebted Chinese corporates and U.S.leveraged borrowers.

 

In our base-case scenario, we project global corporate credit demand (flow) of $62 trillion over 2016-2020, with new debt representing two-fifths and refinancing the rest. Outstanding debt would expand by half to $75 trillion, with China's share rising to 43% from 35%.

 

We estimate that two-fifths (43%) to half (47%) of nonfinancial corporates (unrated and rated) are highly leveraged-of which 2% to 5% face negative earnings or cash flows, based on a sample of about 14,400 corporates.

 

With weakened borrower credit quality, a credit correction is inevitable. Our base case is for an orderly credit slowdown stretching over several years ('slow burn' scenario), but a series of major economic or political shocks, such as the recent Brexit vote in the U.K., could trigger a more system-wide credit contraction ('Crexit' scenario).

Yes, the music is still playing, but it is getting a little fainter with every passing day.