ZYTrade Editors: Corporate America currently owes close to half the entire country’s GDP. We’re talking about a powder keg of debt that’s likely to explode, setting off a massive wave in defaults.
Even before the pandemic reached its height, the IMF was warning in January that the world’s largest economies like the U.S. were unprepared for a slowdown.
Fast forward half a year, with millions of lost jobs and thousands of businesses gone bankrupt in the U.S. because of the novel coronavirus, the word slowdown is inadequate to describe the scale and speed of the economic collapse.
And the pandemic could yet throw another grenade at the economy: A massive corporate debt explosion.
The American economy has lived on debt for a long time. The ratio of the total debt of the government, businesses, and consumers relative to GDP has more than doubled since the 1980s. Record-low interest rates following the 2008 financial crisis further swelled the debt significantly.
U.S. companies owe more than $10 trillion, which is nearly half of the country’s 2019 GDP of $21.5 trillion. Taking other forms of business debt into consideration, including partnerships and small businesses, that figure stands at an eye-watering $17 trillion, the Financial Times reported earlier this month.
“This increase in debt has contributed to increased economic volatility, and has left the country in a weakened position to deal with shocks such as the current virus,” Robert Goldberg, associate professor of finance and economics at Adelphi University in New York, told Newsweek.
In the last few months, this mountain of corporate debt has been compounded by a once-in-a-century event.
Following the lockdown of state and local economies in March, the corporate debt market froze and there was a slump in the issuance of new bonds, in particular for non-investment grade debt.
To get bonds flowing again, the Federal Reserve announced a program to support the corporate debt market, which improved liquidity.
The Fed’s move to buy $750 billion in corporate debt, and the Main Street lending program making $600 billion in loans to small and mid-sized companies, helped indebted firms avoid bankruptcy. But it also added to the debt pile.
Aimed mostly at the investment-grade debt market, the issuance of non-investment grade debt “has skyrocketed” in the last few months, said David Gulley, professor of economics at Bentley University, Massachusetts.
“Long term, however, it’s not clear whether the now highly indebted companies will be able to survive, especially in industries like travel and leisure,” he told Newsweek.
This week, the U.S.Travel Association wrote a letter signed by 14 industry leaders asking President Donald Trump and Congress to expand coronavirus testing to revive the struggling travel sector.
The association warned the travel sector may produce $1.2 trillion less for the U.S. economy by the end of 2020 than the previous year. Many other sectors are suffering and businesses will be looking for lifelines.
“If the defaults become widespread, credit spreads will increase, making it more expensive for companies to raise money to fund operations,” Gulley said.
“Additional business shutdowns and layoffs would occur, potentially on a large scale. The longer the economic problems continue, the more likely it is the defaults will begin to pick up, especially in the non-investment grade sector of the debt market.”
The face value of defaulted non-financial corporate bonds jumped to a record $94 billion in the second quarter of this year, with the U.S. accounting for nearly three-quarters of this figure, according to the Institute of International Finance [IIF].
Emre Tiftik, director of research at IIF, said much depends on the extent to which the virus is contained and treated. “A prolonged period of excess borrowing by corporates is impossible especially if the corporate revenues continue to remain weak,” he told Newsweek.
“The persistent rise in debt levels leaves many corporates even more vulnerable to further shocks and will likely be a major drag on new capital formation and investment while weighing on productivity and growth over the medium term.”
Jonathan Brogaard, finance professor at the University of Utah’s David Eccles School of Business, said he expected to see an increase in defaults in the coming months.
“The much-hoped-for V-shaped recovery seems not to be occurring. Such an increase should not be a surprise given we have seen demand for many products and services decrease,” Brogaard told Newsweek.
“The longer COVID-19 is life-threatening and spreading, the greater the number of defaults that will occur.
“If there is another round of large shutdowns I think governments and central banks will need to extend the support they have been providing to prevent large segments of the economy from failing.”
Companies that needed money to replace earnings lost due to the pandemic rushed to issue debt. Investment-grade corporate bond issuance is already more this year than for the whole of 2019.
But this rate is slowing down. Corporate borrowers have raised $259 billion by selling bonds since the start of July, less than half the $529 billion sold in June and the lowest since the end of year slowdown in December, according to data from Refinitiv.
Jeff Frank, professor of economics at Royal Holloway, University of London, believes that the U.S. government and the Federal Reserve have “grossly over-invested” in their immediate reaction to the pandemic by using tools better suited to a demand shock, rather than a supply shock, which is how he views the current crisis.
These included the $1,200 stimulus checks, the forgiveness provisions of the Payroll Protection Plan (PPP), and the move by the Fed to buy junk bonds.
“The government and the Fed have thrown their entire arsenal at the early stages of the pandemic. The Fed’s balance sheet has already jumped from $4 trillion to $7 trillion, an increase equivalent to the total increase during the financial crisis,” he told Newsweek.
Between January and June, 3,604 companies filed for Chapter 11 bankruptcy, according to data from legal services firm Epiq, a 26 percent annual rise. Tens of thousands more are weighing up whether to make a debt payment on time or keep investment and jobs.
In such an unprecedented crisis, debt maturities put the livelihoods of millions of Americans at stake. Private lenders are unlikely to issue personal or small business loans or corporate debt. Existing loans and lines of credit will have covenants and be recallable, and new lines of credit will be inaccessible.
“The types of policies that make sense are those that help out people in need and those that allow otherwise successful businesses to bridge the gap during a period when private credit markets will be limited or effectively closed,” Frank said.
“That gap, however, is likely to be measured in years rather than months, so bridging a few months of the gap is again pointless.”
Originally posted on Newsweek
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