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Will Debt Weigh Down the Recovery?

By Dean Foust After the Federal Reserve's three-year campaign to bring down interest rates, the conventional wisdom on Wall Street is that Corporate America has mostly acted wisely, using record low rates to clean up balance sheets loaded up with too much debt and soiled by funny accounting in the 1990s. Certainly, many companies have come clean with massive restatements of profits they had reported but never actually earned. And legions of others have refinanced some or all of their old high-rate debt.

Yet, the housecleaning may not be as extensive as optimists would like to believe. According to the Federal Reserve, corporate debt for nonfinancial companies increased 1.4% in 2002, and it rose at an annualized rate of 3.7% in the first quarter of 2003, to a record $4.9 trillion. The rising debt levels wouldn't be worrisome if the borrowing were going toward adding new factories or hiring more workers, but it comes at a time when Corporate America continues to keep a lid on capital spending and payrolls.

PUMPING UP PENSIONS. With profits still on the mend, a number of companies remain reliant on debt just to meet day-to-day obligations. That includes finally covering unfunded pension liabilities -- which, interestingly, have grown even larger as a result of the fall in interest rates. Such is the case at General Motors (GM), which in late June said it plans to sell $10 billion in new debt to make up a huge deficit in its pension contributions.

GM isn't alone: Collectively, the pension plans run by the companies in the Standard & Poor's 500-stock index now are underfunded by a total of $226 billion -- $14 billion more than at yearend 2002. "It wouldn't surprise me to see more companies borrowing to put the proceeds into their pension funds," says David Zion, an accounting analyst at Credit Suisse First Boston.

Likewise, the increased debt load might not be so troubling if Big Business were using the low rates to reduce borrowing costs and begin paying down its heavy debts. Granted, borrowing costs have dropped for many companies: For the 381 nonfinancial companies in the S&P 500, the lower rates helped the group reduce their net interest expenses by a collective $10 billion last year.

TROUBLED BORROWERS. Overall, however, many companies are now devoting a bigger chunk of their operating profits just to servicing their debt. A recent study by Merrill Lynch reveals that the "interest coverage ratio" for the S&P nonfinancial companies has declined steadily since 2000. The ratio, which measures a company's ability to pay its debt service out of operating profits, has seen operating profits slip from 6.3 to 5.3 times debt since 2000, the lowest level since 1995.

Sure, plenty of blue-chip borrowers, such as Gillette (G), have exploited the low rates wisely: The razor giant recently sold $300 million in five-year bonds at a mere 2.5% interest rate. But for every Gillette there's a troubled borrower such as Tyco International (TYC), Qwest Communications (Q), or energy provider Reliant Resource (RRI), all of which must pay more to borrow after seeing their debt downgraded over the past two years from investment-grade to junk status by the rating agencies.

"Everyone who is getting debt restructured now [is] paying higher interest rates than they did before if they're not investment grade," says a Reliant spokeswoman. "That's just how things [work] in this environment."

ALL THAT CASH. With downgrades on investment-grade corporate debt still running at more than three times the rate of upgrades so far this year, analysts believe the trend will result in higher borrowing costs for more companies. "We may have overestimated how much progress Corporate America was making at balance-sheet repair," says John Lonski, chief economist for Moody's Investors Service.

Not everyone is so bearish. Many economists point to the rise in cash on corporate balance sheets -- soaring by $96 billion since 2000, to $449.4 billion, for the S&P nonfinancial companies -- as a sign that many treasurers are exploiting the low rates to stockpile cash for when the economy improves.

Yet others counter that much of the cash increase among the S&P 500 is coming from tech giants that largely don't rely on debt, such as Microsoft (MSFT), which by itself is now sitting on $46 billion in cash -- or $17 billion more than in December, 2000. Factor out tech, and the picture looks far less rosy for sectors like telecommunications and manufacturing that have been historically more dependent on debt.

MASSIVE WRITE-OFFS. Critics note that the cash buildup is partly the result of the sharp cutbacks companies have made in capital investment -- a trend that can continue only so long. "All companies have done is simply postpone capital spending in hopes the business cycle improves and bails them out," says Richard Bernstein, chief U.S. strategist at Merrill Lynch. "That's not balance-sheet repair."

The picture looks bleaker when you examine the other side of the balance sheet, where companies have had to take massive write-offs and writedowns on everything from the prices they paid for acquisitions to the diminished value of factories that were shuttered or scaled back. Among them: AOL Time Warner (AOL), which has taken $99 billion in writedowns against the value of AOL, and Boeing (BA), which after taking a $2.4 billion writedown in 2002 took an additional $931 million hit earlier this year to reflect the reduced value of companies acquired since 1996.

The bottom line: As debt is rising, shareholder equity is falling at some companies, leaving an even weaker balance sheet. AOL Time Warner and Boeing aren't alone: For the S&P 500, the debt-to-equity ratio has risen from 50.9% to 58.5% over the past five years.

All of which suggests that at a time when investors had hoped that the runway had been cleared for the next cycle of growth, many companies are still being weighed down by a lot of baggage from the past. It's a factor that investors will need to watch in the months ahead. Foust is BusinessWeek's Atlanta bureau manager

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