A storm is brewing in the corporate debt market, and it has the potential to threaten the middle market. With the amount of easy capital surrounding this sector of the economy, midsize companies have bitten off more than they can chew if the business cycle were to hit the brakes. And with recent geopolitical events and the coronavirus outbreak, the middle market seems more vulnerable to these rising risks, which could lead to financial trouble down the road.
Some companies loaded with debt may not be able to meet their servicing costs if a downturn hits.
The amount of leverage has grown so high — the St. Louis Federal Reserve estimates that U.S. nonfinancial corporate debt stands at more than $6 trillion — that some middle market companies, even in today’s strong economy, cannot cover their current debt servicing costs.
Leveraged loans
The risk is being driven by an end of the corporate debt market called leverage loans, in which banks and other financial institutions extend credit to companies that carry considerable amounts of debt or have a poor credit history.
These types of loans carry a higher risk of default and as a result are more costly to the borrower. Companies use leveraged loans to finance mergers and acquisitions, recapitalize their balance sheets, refinance debt or for other purposes such as stock buybacks.
Leverage loans charge a floating interest rate and have more forgiving terms, known as covenants. Once sold into the secondary markets, investors find leveraged loans to offer more yield versus other current financial products. According to Bloomberg, more than $500 billion worth of leveraged loans were issued in 2018.
In the S&P/LSTA Leveraged Loan Price Index, the leveraged loan market performed well through 2019 after falling near the end of 2018. The Federal Reserve recently announced that it would keep the targeted federal funds rate steady at 1.50% to 1.75%, which will encourage more lending.
Trouble lurking
A company unable to service its debt due to poor financial performance is known in industry parlance as a zombie company. According to the Bank of International Settlements, 12% of all public companies globally fall into this category.
In the United States, increased leverage is starting to emerge across industries within the middle market, or those companies generating $10 million to $2 billion in annual revenues. These companies contribute 40% toward U.S. gross domestic product and employ a third of the workforce.
The data from Bloomberg shows that the number of middle market publicly traded domestic companies that have an interest coverage ratio of less than one have grown by 44% in the past 10 years. This financial ratio measures a company’s ability to make interest payments on its debt. Companies with a ratio of less than one fit in the zombie category.
But a closer look at the numbers reveals a number of companies in energy, health care and technology with a deterioration in their financial position.
What does this all mean?
The amount of leverage in the system is starting to climb as the cost to acquire and maintain that debt continues to fall. At the same time, the number of middle market companies across industries that have seen their debt service costs deteriorate because of low financial performance has risen.
Another reason why debt is on the rise, especially in health care and technology, represents capital that is needed to grow their ideas, which could lead to future profitability or put them into bankruptcy.
Finally, are these highly leveraged companies stunting the growth of other companies that could benefit from their capital and labor? The U.S. Bureau of Labor Statistics is reporting a tight labor market as the number of unemployed people per job opening equals 0.90 as shown in the chart.
Companies that are looking for skilled workers could be out of luck as the economy moves forward, but could find that much-needed talent during the next downturn. A rebalancing of capital and labor will occur at that time to the best positioned companies for future growth.
Key takeaway: As companies continue to report earnings, keep your eyes and ears open to those that discuss profitability and debt coverage ratios. Time to plan? Yes.
