Debt for U.S. corporates is at a record peak and companies are taking on higher borrowing levels than those that preceded the 2008 financial crisis.
Yet this shouldn’t be a major worry, some market experts argue, thanks in large part to currently benign market conditions and accommodative interest rates.
“The red flags are not going up yet because to a large extent the level of interest rate is actually quite benign,” said Francesco Curto, head of cash return on capital invested (CROCI) and co-head of research at DWS, Deutsche Bank’s majority-owned asset management company.
“So I wouldn’t say there are major concerns there — the ratings of these companies to a large extent are still positive, and everybody is in agreement that post these hikes (from the Federal Reserve) we are not going to see significant hikes coming after this,” Curto told CNBC’s “Squawk Box Europe” on Thursday.
The key word there: “yet.” Not everyone is in agreement with analysts like Curto, and the numbers themselves are fairly staggering. U.S. corporate debt has reached a record $6.3 trillion, according to S&P Global.
More reassuring may be the fact that some of these companies are “awash with cash,” as Curto described, highlighting the $2.1 trillion that the corporates have to service that debt. But it’s concentrated in the hands of a few top companies, while the riskier borrowers are more leveraged than ever before.
The cash-to-debt ratio of speculative borrowers reached a record low of 12 percent in 2017, below the 14 percent level in 2008 — meaning that for every dollar they have in cash, they have $8 of debt.
The International Monetary Fund (IMF) has highlighted this very threat, warning that riskier lending behavior could lead to another crash.
“A period of high credit growth is more likely to be followed by a severe downturn or financial sector stress over the medium term if it is accompanied by an increase in the riskiness of credit allocation,” the IMF said in its Global Financial Stability Report in April.
“Thus, while policymakers should be alert to periods of rapid credit expansion or increasing riskiness of credit allocation, they should pay special attention when they take place together,” the organization advised.
‘A more challenging situation’
Many of these companies borrowed large amounts “under extremely favorable terms in a benign credit market to finance their buyouts at an ever-increasing purchase multiple without effectively improving their liquidity profiles,” wrote Andrew Chang, primary credit analyst at S&P Global.
This could become more dangerous as interest rates rise. The Fed plans four rate hikes this year, although even at this level, they remain relatively low.
Still, Curto was confident that the profitability of the largest companies would keep things stable despite their weighty debt loads, adding that the drivers of equity markets are the large-cap companies.
“The number is big, but to a large extent when you compare it to market capitalizations of these companies, it’s not an absolute number, it’s a relative number, and relative versus the profitability of these companies,” he said. “And it’s very difficult to see the profitability of of these companies coming under severe pressure in the short term, which is why the market’s so benign.”
But a different kind of challenge needs to be kept in mind, Curto added: disruptors and tech companies threatening traditional large-caps who are increasingly consolidating through mergers and acquisitions. If corporate profitability takes a hit, their debt will become a much greater problem.
“The challenges that some of the internet companies are posing will be real, and unless we see significant benefits coming out of these M&A activities, you may see situations where in two to three years’ time, these companies’ profitability will still come under pressure,” Curto said. “And then if you put a cycle over that, all of a sudden you start to see a more challenging situation.”
—CNBC’s Thomas Franck contributed to this article.