Business Reins In Its Debt
Much ink has been spilled on the issue of U.S. indebtedness, both in terms of the rising debt of households and the government and the increasing reliance on foreign capital to fund borrowing. What sometimes gets lost is the strong position of corporations.
Strong profits and low interest rates have allowed nonfinancial corporations to reduce leverage ratios. Only in the last three quarters of 2005 did the financing gap slip into negative territory, requiring net borrowing by nonfinancial companies.
The result is that debt has dropped sharply relative to equity. The ratio of debt to net worth (at replacement value) dropped to 42.5% in the fourth quarter of 2005, its lowest ratio since the third quarter of 1986. Corporate cash flow reached 22.8% of debt outstanding, its highest level since the first quarter of 1985.
At the same time, companies have been building up record cash balances. The net cash holdings of the nonfinancial companies in the Standard & Poor's 500-stock index hit a record $647 billion in the fourth quarter, or 43% (also a record) of outstanding long-term debt.
Companies with high cash balances are likely to use them on acquisitions or investment, certainly good news for mergers and acquisitions.
Companies have not been eager to use the high cash balances to pay down debt for two reasons. First, most have locked in relatively low interest rates, and they are reluctant to pay a penalty to get out of long-term bonds at bargain rates.
Second, the low debt-to-net-worth ratio suggests little reason to reduce debt. This is especially true since credit-quality spreads are still near record lows, giving companies little incentive to improve their ratings.
The low level of debt is surprising for many observers, but is a natural consequence of record profits combined with sluggish investment growth. The record earnings reflect both strong recent productivity growth and low interest rates, which have reduced debt-service costs.
Profits before tax are at a record 12.1% of gross national product (GNP), far above their historical (1959-2005) average of 8.6%. However, this has not come at the expense of labor. Labor income (including proprietors' income) is at 61.0% of gross domestic product, compared to an average 61.5%. Most of the decline has come at the expense of other capital income, primarily rent and interest payments.
There are some problems, however. The first is that debt does not include the shortfall in retirement programs. S&P estimates that the S&P 500 pension funds are underfunded by 12%, or $150 billion.
The shortage in the other post-employment benefits (mainly retirement health care) is even greater, although unlike pensions, these programs are not generally guaranteed forever. This combined underfunding would virtually wipe out the cash balances of the S&P 500, although, unfortunately for retirees, the companies with big cash balances are not typically the ones with underfunded pensions.
Another worry is that despite the improving debt position, the average credit rating of new bonds issued has been declining. In 1980, 78% of the corporations S&P rated were investment grade. Today, only 38% are.
This mostly reflects the increase in the number of companies rated. Back in 1980 no one would pay us to rate them B, but with the growth of the high-yield bond market, even a B rating is useful to a borrower.
In addition, it is the lower-rated companies that are borrowing. The larger investment-grade companies are sitting on lots of cash and don't need new money.
The bonds being issued come from newer, smaller outfits. The low spread between speculative-grade bond yields and investment-grade yields is encouraging these companies to tap the bond market for funds.