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Decade-high leverage at weaker US companies as credit cycle turns


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Decade-high leverage at weaker US companies as credit cycle turns

U.S. companies hold a record $2 trillion in cash, but it is concentrated among a few large players and with the economic outlook still uncertain, a decade-high measure of leverage at weaker firms presents a growing risk.

Cash held by U.S. nonfinancial corporates — which includes liquid investments such as Treasurys — stood at a record $1.92 trillion at the end of 2016, according to data from S&P Global Ratings. The hoard was 10% higher than in 2015 and has almost doubled in the last seven years.

At the same time, total debt has also reached a record, of $5.8 trillion, up $2.2 trillion since 2012.

But removing the top 25 cash holders in the U.S. — about 1% of the companies S&P rates — shows that some $5.1 trillion of that debt belongs to the bottom 99%, which held just $875 billion in cash. Speculative-grade borrowers' cash-to-debt ratio is at a decade low of 13%.

Turn of the tide

While it is no surprise the corporate sector has loaded up on cheap debt fueled by stimulus from central banks post-crisis, there is concern that speculative-grade firms in particular may be overstretched at a time when central banks are looking to withdraw that support.

"In the near term the fact that lower-rated companies have been able to borrow and refinance many times has helped their credit profile," said Andrew Chang, a credit analyst at S&P Global Ratings, adding that while firms' leverage has risen in the last decade, their interest coverage and default rates have been relatively stable.

"When credit conditions do contract that's when we see defaults rise. The credit market today is pretty benign but we are in a very late stage in the cycle."

There is no suggestion that central banks will tighten credit conditions sharply. The U.S. Federal Reserve has been "spoon-feeding the market with clarity" in the eyes of some investors, while the ECB has stressed repeatedly it will act with "persistence, patience and prudence" when it comes to paring back its own quantitative easing program.

But, while the timing of any credit market contraction is impossible to predict, it is clear that the cycle can only go one way from here. The Fed is expected to unveil a plan to reduce its $4.5 trillion balance sheet at its September meeting, while the ECB looks set to begin tapering its €60 billion-per-month asset purchase program in early 2018.

Many already see the markets flashing warning signs, such as European high-yield bonds now offering around 2.3%, the same as 10-year Treasurys.

In its Global Financial Stability Report published in April, the IMF warned that U.S. corporations representing 10% of corporate sector assets now have an interest-coverage ratio of less than 1, meaning those companies cannot pay their interest on their debt from operating income.

Money for nothing?

Whether this surge in leverage is a problem depends on the purpose it serves, according to Gaurav Saroliya, head of global macro strategy at Oxford Economics.

"If you take on higher debt to invest in new productive capacity, then the leverage built up may not be a problem. However, in the U.S., a lot of the new debt since 2008 has gone into share buybacks, which has maintained stock prices artificially at high levels even in the face of negative earnings growth over 2015 and 2016.

"I would be wary about dismissing higher leverage as simply a rational capital structure decision. It's fine [while] stock-price valuations remain high. A lot of pain will be heaped on U.S. firms if there is a market correction."

Much of the cash hoarding has been in the technology sector, which held a record 47% of the total U.S. corporate cash pile at the end of 2016, according to data from Moody's. Tech firms such as Apple Inc., Microsoft Corp. and Google Inc., which earn a substantial portion of their income overseas, have built up cash offshore to avoid paying repatriation tax, preferring to borrow at low rates domestically.

The tech and healthcare sectors between them account for some 60% of the $2.2 trillion of cash balances held overseas, according to Saroliya, who does not view cash reserves as a "grand panacea" for the U.S. corporate sector.

"These sectors are also the ones that have most engaged in what the IMF calls financial risk taking, such as M&A, rather than economic risk taking — creating new productive capacity and R&D," he said. "So it's not clear how much of the cash piles is a genuine support to those sectors.

"You can view large cash piles as a source of strength. But you can also regard them as an insurance policy not only against when funding dries up but for when innovation decay sets in and profitability begins to decline structurally."

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.