Corporate America is Feeling the Pain: Debt Spiral

Thanks to the Federal Reserve, years of easy credit may bring about new financial woes for US corporations. As the Federal Reserve raises interest rates, overextended corporations are easing up on borrowing, but could face a long-term debt-repayment problem.

The debt/earning ratio rose to 37 percent in 2017, up 10 percent from a decade ago. Combined with higher interest rates, a recession may loom in 2019. Burdened with overwhelming debt, corporations will need to find ways to cut costs and reduce expenses. This could lead to layoffs and higher unemployment, despite the current positive employment outlook.

Many companies are taking steps to scale back their credit, and money managers are looking to reduce their exposure. Brandywine Global Investment Management, with a total of $74 million in assets, has reduced its debt exposure to 5 percent, down from 50 percent. TCW Group Inc. has been decreasing its debt exposure for the past year. Money managers are simply becoming more cautious.

US investors are being more selective with their risks, especially in the junk-bond market. Credit is, of course, still available. Recent corporate tax cuts have enabled companies to restructure their debt model to reduce the chances of defaulting on debt. Still, a record number of companies are suffering from debt overload. While corporate defaults in 2017 were at a three-year low, the situation can change very quickly even for established companies, as evidenced by the recent bankruptcy filing of Toys “R” Us.

More corporate bankruptcies and defaults are expected through 2019, as noted yesterday. 

According to David Ader, who is the chief macro strategist at Informa Financial Intelligence, the debt of US nonfinancial companies is at a record high of $8.7 trillion, comprising 45 percent to total GDP. This debt to GDP ratio is higher than during the dot-com bubble and could become worse still unless the Federal Reserves raises interest rates instead of keeping rates artificially low.

We recently caught up with Danielle DiMartino who is a former Federal Reserve insider and the author of the book “Fed Up”:

Persistent zero-interest-rate policy creates the classic bad outcome of good money chasing after bad. ZIRP is why housing and education costs are so high, it’s why every asset market is more inflated than it’s ever been in history, and it’s why central bankers worldwide are so far behind the curve. – Danielle DiMartino

President Trump’s tax cuts could free up more corporate funds for debt repayment. The long-term effect of these tax cuts on corporate debt is still unknown, but investors are wise to be cautious as more companies are expected to go into default.