Rising Junk-Debt Loads Erode Credit Quality, Morgan Stanley Says

The record pace of U.S. junk-bond sales is weakening the credit quality of speculative-grade companies as debt loads expand and cash piles erode, according to Morgan Stanley.

U.S. junk companies increased borrowings by 10 percent in the first quarter from a year earlier while the ratio of cash to debt fell to 9.6 from almost 15 percent in 2010 and is approaching the long-term average of 8.7 percent, strategists led by Adam Richmond in New York wrote in a note to clients dated today. Even as earnings growth slows the economic expansion sputters, companies are “no longer feeling the need to hoard cash,” they wrote.

“Low rates have served as both a positive and a negative driver of corporate fundamentals,” the analysts wrote. While “low rates have allowed companies to lower coupon payments, in some cases quite dramatically, and push out upcoming maturities in the process,” they wrote, “today’s record low cost of debt has given companies the incentive to issue debt and increase leverage.”

Yields on junk debt, rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s, have jumped 37 basis points, or 0.37 percentage point, from a record low of 5.98 percent on May 9, according to Bank of America Merrill Lynch Index data. Yields have climbed as investors weigh whether the Federal Reserve may start scaling back unprecedented stimulus efforts that suppressed interest rates and pushed investors into riskier types of debt to boost yields.

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The average ratio of debt to earnings before interest, taxes, depreciation, and amortization, or Ebitda, has climbed to 3.92 times from 3.42 at the end of 2011, according to Morgan Stanley data. The gap between leverage ratios of higher- and lower-rated junk companies also is converging as higher-ranked firms issue at a faster pace, the strategists wrote.

High-yield companies have issued $192.5 billion of debt this year, ahead of the $140.7 billion issued by this time in 2012, when a record $358.5 billion was sold, according to data compiled by Bloomberg.

“As long as rates and volatility both stay modestly low, we do not think leverage will start dropping,” the Morgan Stanley strategists said. “Any increase in Ebitda will likely be matched by a proportionate increase in total debt, as companies continue taking advantage of highly attractive new issue markets.”

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