American corporations are racking up debt at a historic pace. Indeed, US corporate debt now stands at a staggering $6.3 trillion. That far outstrips corporate debt level before the 2008 Financial Crisis and is now a new record. It is also a ticking time bomb that will blow apart the US economy.
Two factors have triggered this surge in debt.
First, US interest rates have been unusually low (near 0%) for almost a decade. This has meant that corporations could increase their leverage well above previous levels because interest payments were minimal.
Unfortunately, low interest rates are already going away as the Federal Reserve (Fed) is steadily raising interest rates. Indeed, the Fed has already pushed rates from around zero to 2% now. The Fed has also signaled it intends on raising rates by a quarter percent for the next year and change.
This will naturally translate to much higher interest expenses on corporate debt going forward. That will weigh heavily on the bottom line of over-indebted corporations. It will also squeeze business investment going forward.
The second factor driving up corporate debt is the huge tax cuts corporations received last year. This sounds counter-intuitive but it is the case. Corporations rushed to return capital to investors once the tax cuts passed.
Each one wants to outdo its peers. Accordingly, corporations are loading up on debt to buy back shares, pay unsustainable dividends, and resorting to a myriad of other financial engineering tricks. This has driven US corporate debt through the roof.
US Corporate Debt is a Ticking Time Bomb
While the headline corporate debt numbers look bad, it’s even worse when you dig a little deeper. The real problem is that the least creditworthy companies are also taking on the most debt.
Analysis by credit rating agency Standard & Poor’s shows that the riskiest borrowers are more leveraged than they were even during the financial crisis. Indeed, speculative-grade borrowers reached a new record-low cash-to-debt ratio of just 12% at the end of last year. That is below the 14% reported before the 2008 Financial Crisis.
On top of that, more than 450 investment-grade companies have cash-to-debt ratios similar to those of speculative issuers. Their cash to debt ratio is hovering around just 21%.
Many of these debt-addicted corporations need low-interest rates and a robust credit market to survive. This means they’re essentially living on borrowed time because interest rates are already going up.
We’re already in the second longest economic expansion in US history. Accordingly, it’s only a matter of time before the economic cycle turns and credit dries up.
The combination of rising interest rates and lack of credit will eventually cull debt-laden corporations. The US economy will also inevitably suffer a setback as that happens.