A burgeoning debt load in Canada’s corporate sector could make an economic recession deeper and more long lasting. One economist says that low interest rates and income interruptions could work in tandem to dig the country into a corporate default spiral that’s harder to bounce back from.
“For now the most serious impact on the economy in the next quarter will be due to the restrictions on activity such as restaurant, retail and factory closures,” explained Stephen Brown, senior Canada economist at Capital Economics, “but the risk of corporate debt defaults raises the chance that the eventual recovery once businesses open again will be far slower than it might otherwise be.”
Heading into this market meltdown, Canada’s corporate debt loads were already at precarious heights. According to a report by TD Economics from early February, Canada’s debt-to-GDP ratio in companies outside of the financial sector rose to 118.7 per cent. This ranked it third highest in the G20, behind China and France. The last surge in corporate debt followed the 2015 oil price crash that had the Bank of Canada cut interest rates, shown in a chart in the report. Cheaper debt sparked a borrowing binge for companies and households.
The TD Economics report also warned that in an economic downturn high corporate indebtedness could create widening corporate bond spreads and a spike in delinquency rates.
In the 2019 Financial System Review, the Bank of Canada reported that non-financial corporate debt was 315 per cent relative to income. As income streams are further challenged with supply chain interruptions and a drop in consumption caused by social isolating, these debt-to-income ratios can very well deviate further.
Since mid-March, the Bank of Canada has made two interest rate cuts of 50 basis points, bringing the current benchmark overnight rate to 0.75 per cent. The cuts bring the costs of borrowing to the same lows we saw in the 2015 market downturn. This easier access to borrowing will help ailing companies suffering from COVID-19 impacts today, though at the cost of much higher debt liabilities in the long-run. These could send companies in certain vulnerable sectors into bankruptcy.
Sectors In The Crosshairs
Oil & Gas
The oil, gas and mining sector is one of the more over-stretched industries: “The energy sector looks most at risk - that’s because debt levels are already much higher than the other two following the 2014/2015 oil price crash,” Brown said.
With a recent plunge in oil prices, the energy sector faces lower revenue and more debt to service, meaning companies with weaker balance sheets heading into the crisis are the most at-risk of bankruptcy.
TD economists also highlighted the leverage risks within the energy sector: the February report stated that the oil sector holds 45 per cent of non-financial corporate debt, along with the real estate and manufacturing sectors.
COVID-19 struck the transportation industry particularly hard, prompting over 15,000 temporary layoffs and suspended operations to limit the spread of the virus.
Many airlines were on solid footing heading into the crisis, but the service interruptions can can deal a body blow to financial statements. According to a transportation report by the National Bank of Canada, the companies with the strongest balance sheets will survive the COVID-19 crisis. Most of the companies outlined in the report had a low debt-to-EBITDA ratio with Bombardier’s glaring exception of an 8.1x ratio. Anything higher than a four or five usually raises red flags.
With declining revenue and lower profit expected in the upcoming quarters, these ratios will likely grow. Factor in the low cost of borrowing put in place by the government and these ratios can jolt upward for companies with already high debt loads.
More Fuel for the Debt Fire
The Bank of Canada continues to make moves to improve business liquidity, the latest being its restated authority to purchase company debt while “addressing a situation of financial system stress that could have material macroeconomic consequences.” The Bank of Canada has signaled it may launch its first-ever quantitative easing program to keep borrowing costs low and support ailing industries that were directly affected by the COVID-19 crisis – particularly the travel, energy, and retail sectors.
These measures should counterbalance rising unemployment levels and an economy expected to shrink between 10 per cent and 24 per cent on an annualized basis, according to bank economists. “Canada’s government has said that there are likely to be specific packages designed especially for the energy sector and for airlines at some point soon,” Brown explained, “which seem to be sorely needed.”