While the global economy is currently reeling from the immediate effect of the coronavirus outbreak on businesses, the virus has also exposed a much deeper issue which could cause more serious damage, a huge bubble of corporate debt.
As a result of low interest rates in the years following the financial crisis, firms took the opportunity to borrow ever larger sums of money through the issue of corporate bonds, a strategy that caused company debt to balloon to nearly US$13trn at the end of 2018, twice as much as in 2008.
According to a 2019 report from the Organisation for Economic Co-operation and Development (OECD), 76% of this debt is held by companies in so-called ‘advanced economies’ such as the UK and the US, with the body adding that in the years following the financial crisis multiple regulatory initiatives had encouraged “the use of corporate bonds as a viable source of long term funding for non-financial companies and an attractive asset class for investors”.
As a result, the OECD calculated that companies across the world will face “record levels” of repayments in the coming years.
“As of December 2018, companies in advanced economies need to pay or refinance US$2.9 trillion within 3 years and their counterparts in emerging economies US$1.3 trillion. At the 1-, 2- and 3-year horizons, advanced and emerging market companies have the highest corporate bond repayments since 2000”, the organisation said.
Recession could be amplified by debt levels
The OECD went further in its report by saying that these massive corporate debt levels were like to “amplify” any effects of an economic downturn as “highly leveraged companies would face difficulties in servicing their debt”.
These so-called ‘fallen angels’ (companies that cannot service their debt) were likely to see their credit ratings downgraded below BBB to non-investment grade, the OECD said, and that this will result in the companies having to face “an amplified increase in borrowing costs” and a smaller pool of investors to which they could offer their debt.
The OECD estimated that as much as US$500bn in corporate debt could fall into non-investment grade territory in the next economic downturn, causing an economic “shock”.
Divis also at risk
Aside from the corporate bond risks, investors are likely to look closer to home as companies that have their business restricted by coronavirus look for other ways to preserve their cash, including dividend cuts.
“What will be interesting to see is whether CEOs and boards choose this moment to rebase their dividends.”, said AJ Bell’s Russ Mould.
He added that the current 1.68 earnings cover for 2020 suggested that FTSE 100 firms were “over-distributing, perhaps to curry favour with income-hungry investors, and they may take the feared economic setback as a chance to reset pay-out expectations, so they can better balance the need for investment in the business, the desire to pay down debt and the requirements of the pension fund with the demands of shareholders”.
Mould also said that in the event of a recession commodity sensitive stocks such as miners will find their profits “under pressure” and could restrict their cash balances.
“Banks may have to rein in dividend plans too”, Mould said, as interest rate cuts will place pressure on net interest margins.