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A $1 Trillion Liquidity Surge Is Morphing Into a Leverage Boom

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Paula Seligson
·7 min read
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(Bloomberg) -- It was supposed to be a temporary buffer -- more than $1 trillion of debt taken on by U.S. companies last year to ride out the economic devastation caused by Covid-19.But with the economy rebounding and interest rates still near all-time lows, it’s becoming increasingly tempting for corporations including Home Depot Inc. and Verizon Communications Inc. to spend those cash cushions on acquisitions and dividend hikes. In many cases, they’re now borrowing more.

The risk is that unfettered access to cheap debt -- even for less creditworthy companies -- will ease the pressure on executives to pay down their liabilities. That could extend a decade-long trend of swelling corporate debt levels, increasing the chances of a greater reckoning once interest rates rise or the next time capital markets seize up.

“Today’s liquidity becoming tomorrow’s leverage is going to be the story of 2021 for at least some companies,” said David Brown, co-head of global investment grade fixed income at Neuberger Berman, which has $405 billion in assets.

Rising Cash

Total debt loads for U.S. companies outside the financial industry rose 10% in 2020 to $11.1 trillion, according to the Federal Reserve, in part because lower interest rates have made it less burdensome for many companies to shoulder more debt. So far, corporations have largely been hoarding the money rather than spending it. Non-financial companies in the S&P 500 index that reported results before March 31 had about $2.13 trillion of cash and marketable securities on their books in the most recent quarter, up more than 25% from a year earlier, according to data compiled by Bloomberg.

But that’s likely to change, according to strategists at Barclays Plc. With the U.S. giving Covid-19 jabs to more than 3 million people a day now, and the economy showing signs of a resurgence as more consumers feel safe to go out and spend, companies are likely to be more aggressive in deploying cash.

That’s likely to show up in the form of dividends, share buybacks, acquisitions, capital expenditure, and debt repayments, Barclays strategists led by Shobhit Gupta wrote in a report on Friday. Their analysis of comments on company conference calls shows that more management teams have been talking about making one-time dividend payments in recent months, and have been discussing buying back shares. The volume of acquisitions has also been growing.

Generally, companies with higher credit ratings, in particular those at least four steps above junk, are likely to feel comfortable maintaining higher debt levels, the strategists said. Those with lower grades are more likely to pay down obligations.

Home Depot sold $5 billion of bonds in March 2020, saying soon after that it wanted to make sure it had enough cash to tide it over during the pandemic. Then in January it borrowed $3 billion more for its acquisition of HD Supply Holdings Inc., its former subsidiary serving professional contractors. In February, the retailer said it was increasing its quarterly dividend by 10%. Meanwhile, total debt jumped by about $5.8 billion over the company’s fiscal year.

Higher Earnings

Investors don’t always get hurt when a company boosts its borrowings. In the case of Home Depot, its earnings have risen alongside its liabilities, as the pandemic has spurred house-bound people to fix up their properties.

The retailer prepaid $1.35 billion of bonds in March, and credit-rating firms aren’t looking at downgrading the company, which is ranked five steps above junk by Moody’s Investors Service and S&P Global Ratings. But analysts have said the boom in home improvement may fade in the coming year as people finish their projects and spend more time outside the home as the pandemic eases.

Most money managers viewed companies’ extra debt as being short-term. Verizon said in April 2020 that it was issuing notes to boost its cash levels, describing the move on a call with investors as a step to help it “manage through the impacts of the Covid pandemic.”

Then last month it sold more than $30 billion of bonds in multiple currencies, swelling its total debt to a record high in the process, to help finance purchases of 5G spectrum. The company views the rise in leverage as a temporary move to fund a strategic asset that positions the company for growth, according to an emailed statement from Treasurer Scott Krohn in response to an inquiry from Bloomberg.

“For many industries, this liquidity was supposed to be temporary,” said Terence Wheat, senior portfolio manager of investment-grade corporate bonds at PGIM Fixed Income, who declined to comment on any specific corporation. “Now some companies may use it for acquisitions rather than paying down debt.”

Lower Penalties

Corporations are borrowing more now for the same reason they’ve been boosting debt levels for years: because they can. The average yield on an investment-grade corporate bond was just 2.2% as of Monday, far below the mean of the last decade of around 3.17%, according to Bloomberg Barclays index data.

And companies are finding that adding on more debt doesn’t necessarily hurt them much. The penalty for a ratings downgrade is generally minimal. A corporation in the BBB tier, or between one and three steps above junk, pays about 0.47 percentage points more yield than companies in the A tier, or four to six steps above speculative grade, according to Bloomberg Barclays index data. That’s close to the lowest difference in a decade, and according to Barclays strategists, reflects the fact that insurance companies have been buying more BBB debt.

That shrinking penalty may be why more than half of investment-grade corporate bonds by market value are in the BBB tier, versus just 27% in the early 1990s. Typically, most investment-grade companies can choose to pay down debt and merit higher ratings if they wish.

“Companies have chosen to lever up,” said Richard Hunter, global head of corporate ratings at Fitch Ratings. “The wild card is going to be companies’ choices now.”

Acquisition Time?

For some North American companies, buying competitors looks like a good use of cash, as it can allow them to boost future earnings. Canada’s Rogers Communications Inc. said last month that it plans to acquire Shaw Communications Inc. for $16 billion. Its debt levels are expected to rise to more than five times a measure of earnings, a leverage ratio commonly associated with junk credit ratings. But the company said it plans to delever to a ratio of 3.5 times over the next three years.

Rising profits for companies have helped make their debt levels look less worrisome by at least one measure. The ratio of corporations’ earnings to their interest costs has been climbing for the last few quarters, signaling they have more income available to pay their debt. For investment-grade firms in aggregate, that ratio is now better than it was pre-Covid-19, while the metric for junk-rated companies has almost returned to levels before the pandemic, according to Bloomberg Intelligence.

High cash levels at companies make indebtedness look lower now by some measures. Net leverage, which subtracts cash from debt and compares that net debt level to a measure of earnings, is near pre-Covid-19 levels for both blue chip companies and riskier speculative grade corporations on average. Total leverage, which doesn’t subtract out cash, remains significantly higher that it was pre-pandemic, according to a Bloomberg Intelligence analysis of the investment-grade and high-yield corporate bond Bloomberg Barclays indexes.

If companies keep spending their money instead of paying down debt, net leverage will rise, said Noel Hebert, director of credit research at Bloomberg Intelligence.

“Ratings agencies have become comfortable with higher and higher leverage, thus companies are more and more happy to take advantage of it,” Hebert said. “There’s an incentive to hold leverage at elevated levels because there’s no real mechanism that’s punishing you.”

(Updates with detail on insurance company demand in paragraph 16)

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