Preparing Today for the Next Contraction in Credit

Preparing Today for the Next Contraction in Credit

U.S. non-financial public companies have endured through an unprecedented period of financial leveraging, mostly due to record-low interest rates. This shift in corporate capital structures now poses a threat to supply operations as well as accounts receivable portfolios. Counterparty financial risk is a growing problem in today's business world, and comprehensive risk management procedures have never been more important.

It’s necessary to have suitable tools available to manage the risks posed by an increasingly leveraged corporate world, whether those risks materialize today or develop in the future. It's worth noting that the last three business cycles have lasted about eight years on average- notable today, as the same amount of time has elapsed since the end of the Great Recession (which officially lasted from December 2007 to June 2009). 

2018 is not the time to let your guard down. Once the next credit cycle downturn occurs, trade credit and procurement professionals will need to act decisively to protect their respective businesses. 

The Change

Since the start of 2017, a significant number of public companies have issued new debt to take advantage of the low interest rate environment. In most cases, corporations have issued debt to fund stock buybacks and pay dividends, as well as to avoid repatriating offshore earnings because this would raise their tax bill. Some of this borrowing can also be attributed to aggressive merger and acquisition activity. 

However, this debt binge has consequences. For example, Standard & Poor's research recently noted that roughly two-thirds of U.S. non-financial public companies now have non-investment grade or junk rated debt. Most of this is due to high financial leverage, especially considering the risk high leverage can pose through an economic cycle.

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To examine this issue in more detail, CreditRiskMonitor generated a sample of more than 4,000 non-financial public companies based in the United States. First we looked at debt relative to total assets. Between 2011 and 2016, the median figure for this group showed an increase of 26%, quite a significant buildup:

Debt relative to total assets for U.S. public companies, 2011-16.
Debt relative to total assets for U.S. public companies, 2011-16.

Looking at the transition in a different way, the next chart shows U.S. corporate shareholder equity relative to total liabilities. The median equity to liabilities ratio for this group slowly declined to a level of 78%. However, if we examine the bottom quartile, this group of companies experienced a more significant deterioration, falling to a scary 29% figure. Lastly, the bottom decile shows more liabilities than assets on their books, on average.

U.S. corporate shareholder equity relative to total liabilities, 2011-16.
U.S. corporate shareholder equity relative to total liabilities, 2011-16.

Moving onto performance, we can see that publicly traded companies' capacity to pay annual interest expenses is another concerning trend. The increasing debt loads companies are taking on limits financial flexibility in times of stress. Over the last six years, the median interest coverage ratio of these companies fell from five times to less than four times.

U.S. median interest coverage ratios, 2011-16.
U.S. median interest coverage ratios, 2011-16.

These are concerning developments, even more so when viewed in the context of the changing interest rate environment. In the last three years, three-month LIBOR has increased from 0.2% to approximately 1.4%. In September 2017, the Federal Reserve strongly suggested that there would be another rate hike before year end. If we assume this hiking cycle continues or economic turmoil surfaces, we could observe a material spike in default rates, particularly regarding lower grade businesses.

Another Hazard

Looking at today's record-high stock prices and the ample liquidity available in credit markets, you might be tempted to ignore this increase in leverage. The problem is that these two issues are interconnected. In fact, the correlation between equity and bond securities has increased significantly over the last decade. This change might be forwarded by the idea that debt purchasers are effectively using the market value of equity as insurance. 

The apparent expectation is that companies will be able to tap the capital markets in some fashion no matter what happens. However, the lowest grade borrowers with floating rate debt will be among the first to feel the pinch of higher rates. Such operators will find themselves facing higher borrowing costs and limited access to equity markets. Companies that leveraged themselves too aggressively may find they have little-to-no financial flexibility to deal with adversity. 

Bottom Line

In a slow growth economy, businesses are tempted to ignore longer term financial risk if it means growing market share or reducing costs today. Now could be one of the worst times to walk away from the credit function or become lax in protecting your supply chain given steepening levels of corporate financial leverage. 

Ultimately, capital allocation strategies that unilaterally favor debt today fundamentally undermine the safety of unsecured creditors. As short-term interest rates spike higher over the next few years, default rates - as well as corporate restructurings - may arise more frequently. In effect, all counterparties should be aware of specific industries and companies that are most exposed to this transition.

About CreditRiskMonitor

CreditRiskMonitor is a financial news and analysis service designed to help professionals stay ahead of public company risk quickly, accurately and cost-effectively. More than 35% of the Fortune 1000, plus thousands more worldwide, rely on our commercial credit reporting and predictive risk analytics for assessing the financial stability of over 58,000 global public companies.

At the core of CreditRiskMonitor’s service is its 96% accurate FRISK® score, which is formulated to predict public company bankruptcy risk. One of four key components calculated in the FRISK® score is crowdsourced subscriber activity. This unique system tracks subscribers' patterns of research activity, capturing and aggregating the real-time concerns of what are essentially the key gatekeepers of corporate credit. Other features of CreditRiskMonitor’s service include timely news alerts, the Altman Z” score, agency ratings, financial ratios and trends. CreditRiskMonitor’s network of trade contributors provides more than $135 billion in trade data on their counterparties every month, giving them visibility into their biggest dollar risks.