Written by Josh Papson – – COVID-19 is turning the world on its head and companies are turning more often to debt to keep their businesses afloat amid slowing consumer demand. With interest rates at their lowest ever, it seems foolish not to be grabbing as much free money as possible…  right? If companies are now at their weakest, investors at the most feverish, and the world at its most uncertain, how do we (the investor, student, professional) look at the markets today? And, with everyone and their mom (Hey, Mom!) raising record amounts of debt, where does that leave us when rates eventually return to “normal?”

Free money, rates drop to zero

With the recent stimulus activity from the Federal Reserve (“Fed”), the interest that banks pay to the Fed went to zero — the lowest they’ve ever been in the U.S. The Fed uses interest rates to stimulate or suppress economic growth through Monetary Policy and Quantitative Easing. Using English, the Fed buys or sells U.S. treasury bonds and other government debt to release more or less money into the economy. Per the laws of supply and demand, more dollars available means each dollar is worth less. Simply, the Fed has put so much money into the system that interest on government loans, the time value of money, is basically worth nothing, hence a 0% interest rate.

With COVID dropping economic growth to new lows, the Fed is committed to “doing whatever it takes” to mitigate a depression. While that may seem sensible at first, the statement is pretty heavy considering the Fed has, practically speaking, unlimited and unchecked money printing power. 

Not just the US, everyone’s doing it

Also, we’re not the only ones. Across the globe, central bank intervention has been rampant and interest rates are really low. Sometimes, negative low. Japan and Germany are two infamous examples of negative interest rate environments where their “Fed” is so desperate to stimulate growth. Negative interest rates mean if you stick $100 in a bank, you’ll only get $99 at the end of the year. If that seems backwards to you, you’re right. The message here is that the Bank of Japan and the Deutsche Bundesbank want its citizens to invest in their own businesses and increase consumption instead of saving it. The same logic applies in the U.S. to a lesser extreme, but I wanted to point out that the U.S. is likely not alone in the following issues.

Why equity, why debt?

Businesses have two main ways to fund themselves; debt and equity. To understand why companies use one or another, it’s important to recognize that each type has opportunity costs and real costs for the company. Equity (read: Shark Tank) is direct ownership in a company. As an owner, you do well when the company does well and visa versa. While there’s no initial cash cost of issuing equity, the company forgoes a share of future earnings making it extremely costly for the high growth enterprise.

With debt, the lender only owns the rights to collect a specified amount of interest and principal payments. But, if the company goes bankrupt, they have claims (before stockholders) on reclaiming their owed money. The relative safety of a debt investment “compensates” them for accepting a lower potential return. Given the lower cost to the company, debt is usually the preferred financing tool for most normal businesses. From the perspective of the company, this table sums up the cost dynamics:

1: Some types of debt allows conversion to stock, giving the investor the best of both worlds. But, that’s not what we’re talking about.

With rates like this, debt, debt, debt

So, when the Fed slashed rates in March, it was music to businesses’ ears. Their “low cost” funding just got considerably cheaper. Throw COVID in the mix, and now businesses are strapped for cash. Well, well, well! What better time to take on debt than when it’s cheapest. And, companies did just that.

Here’s the kicker – riskier companies have to pay more in interest than safer companies – a lot more. Currently, most companies are considered riskier than they were before COVID. Moody’s and Standard and Poor’s (S&P) are rating agencies that analyze companies’ financial health and publicly report on their riskiness. There is a complicated grading scale, but for our purposes there are two main buckets: Investment-grade (strong companies) and non-investment grade debt (weak companies). The latter is gracefully dubbed Junk Bonds. Moody’s and S&P update these ratings annually but review them periodically for any sudden and drastic changes in financial health. Any deterioration in health will result in a downgrade, and a bad enough downgrade sends you to junk territory.

This graph from Bloomberg shows the BB/BBB spread; the difference in interest rates between junk debt and good debt. Higher spreads translate to less confidence in the bad debt and a higher perceived risk of default. Simply put, junk debt currently costs about 3.5% more than good debt. And, estimated by JP Morgan analysts, over $215 billion of corporate debt ($7.5 billion in extra interest) will convert to junk status in 2020. 

Corporate credit card spending spree

With costs of borrowing low and growth estimates uncertain, companies are flocking to raise cash for their rainy day funds. So far in 2020, corporations have raised over one trillion dollars — with a T — in corporate debt, $160 billion of which comes from the high-yield, junk markets. CNBC reports that companies have raised debt at nearly double the pace of 2019, as of May. Name a company, and I’d bet they raised cash this year. Here are some of the biggest deals yet:

2: Boeing also agreed to take $60 billion in federal aid.

Notice all the B’s in front of the -illions. Lots of cash is floating around now, but investors are still taking to the issuances cautiously. For companies like Delta Air Lines, Carnival Cruise Line, and Macy’s, who operate in struggling sectors, investors are demanding a premium for the bankruptcy risk they’re taking in the form of 7%+ interest rates. With rates low and equity markets filled with uncertainty, investors need some fixed yield to nest cash away. 

Call me Chicken Little, but. . . 

Let’s sum up the story so far. A global pandemic slowed growth and innovation to new lows. Consumer demand plummeted, and global supply chains halted. Corporate debt, since previously cheapened by central bank intervention, has skyrocketed to 74% of U.S. GDP, according to Forbes. Strong companies are issuing debt, seemingly unnecessarily, to continue dominating, but weak ones are using the opportunity as a last resort life raft. Thousands of companies across the retail, transportation, financial, and energy sectors already filed for bankruptcy. And, thousands more will have their credit rating severely downgraded, limiting the efficacy of their last ditch effort. None of that is comforting to me.

. . . Corporate zombies are worrisome

13D, a strategy and research consultancy, argues that companies increasingly are not able to take on additional debt safely in 2020. They note that one in six U.S. companies are “Zombies.” These are companies whose earnings before interest and taxes (a.k.a. EBIT, read: operating profit) are less than their interest expense. Zombies must rely on interest rates to stay low and consumption to increase, but in the meantime, they will hemorrhage through their cash reserves. As a result, corporate cash reserves decreased 11% in the trailing twelve months from November 2019, which is “the largest percentage decline since at least 1980.” Companies today are leveraged more than ever before and have increasingly less cash to pay for it.

With debt, the question to ask

Let’s look past the doomsday talk for a second. Corporate America is in a real bind right now, but frankly, they’re probably doing the best they can. There’s a short-term need for cash, so greater interest expense and maybe a few unprofitable quarters is better than going through bankruptcy court. Despite all the red flags, debt itself isn’t inherently a bad thing. It’s much more important to understand:

1. Why is the company raising cash?
2. What are they using it for?
3. How much are they paying for it?

Establishing this framework gives you a solid glimpse of a company’s current financial health. Macy’s raised over a billion dollars at around astronomical 8.4% to pay down an existing debt facility and cover cash shortages from rent expenses and decreasing sales volume. It seems that Macy’s has a lot of fixed costs associated with their real estate and previous supplier contracts severely hurt them. Retail headwinds from e-commerce growth in 2019 have not subsided either.

Apple on the other hand raised 8x that amount at around 4% to pay dividends, buyback stock, refinance (more expensive) debt and invest in working capital — all signs of healthy and productive uses of debt. With over $190 billion in cash on hand, Apple’s recent raise may seem to some as superfluous, but in any case, Macy’s and Apple are not the same. Understanding why a company has raised debt during this financing cycle is an important first step in understanding the impact on their business.

Caveat Emptor: Buyer Beware

With all the uncertainty and confusion surrounding markets amid COVID, a few tenets remain steadfast. First, investors flock to equity markets when rates drop in search of yield. We can expect a sharp recovery in stock prices given the stimulus from the March Fed minutes. As of June 9, this thesis came true as S&P 500, NASDAQ and Dow Jones indices erased all losses for the year. And as of June 10, the Fed Chairman is committed to keep rates around 0% “through 2022.” While another discussion can be had on the bifurcation of the recent rally and economic reality, we are currently seeing the supply and demand of investments at work.

Second, during times of uncertainty, investors will search far and wide for yield. But, they will always demand to be compensated for taking on risk. Aforementioned, fixed income is relatively low risk with almost guaranteed payments and return of principal. In a time when rates are near zero, any similar debt investment with excess return will be desired by some class of investors. But, as we’ve seen in many distressed cases (Carnival Cruises, Delta Air Lines, Macy’s), the market is demanding coupons upwards of 8% over the risk-free rate to be compensated for the relative probability of bankruptcy.

For perspective, the stock market returned around 8% annually over the past 50 years, after inflation. In a world where risk = return (and visa versa), look to the interest rates on these recent debt financing as a gauge of relative risk. If you own stock in the underlying company with an outrageous interest rate, maybe it’s time to reevaluate your equity investment and consider a more senior (read: safer) debt placement instead.**

Last, while investment is usually made looking at the income and cash flow statements, make sure to unpack the balance sheet too, especially during these unprecedented times. Oftentimes, investors look to profitability and cash flow generation as signs of a good investment. While I think earnings have become less important to the average investor as of late (ie: Uber, Spotify, Snapchat don’t make a profit), it is important, now more than ever, to rely on a solid balance sheet to mitigate idiosyncratic risk. Companies with large cash reserves, low leverage ratios and low receivables (indicative of high brand value and strong supply chain power) will be aptly equipped to batten the hatches and weather the COVID storm.

Unequivocally, there’s a lot of uncertainty in the bond and stock markets today. But, with the recent flooding of corporate debt issuances, we should be wary of the increasing trend towards unsustainable debt levels despite fantastically low interest rates. Although many are worried about a second wave of COVID, we should take care to ensure that it is not accompanied by a wave of corporate insolvencies.

What do you think?

• Can debt be good for some companies to best position or reinvent themselves?
• Who comes out winning?

Sources and useful links

• Corporate debt issuance has already topped $1 trillion in 2020, Axios, D Rabouin, May 11, 2020
• A corporate debt reckoning is coming, 13D Research, April 2, 2020
• U.S. high-grade corporate bond issuance sets weekly record, Reuters, K Duguid, J Franklin, April 2, 2020
• 5 facts about the national debt, Pew Research, D, DeSilverJuly 24, 2019
• Corporate Debt, Distress and More Borrowing, WSJ, S Goldfarb, Y Martinez, May 10, 2020
• Active Investing in the Age of Disruption, Evan Jones, April 21, 2020

* Disclosure: I am long AAPL, DAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it, nor do I have any business relationship with any company whose stock is mentioned in this article.

** This statement nor others in this article should not be misconstrued or taken as investment advice.