This post originally appeared in Forbes as part of the Intelligent Investing series. In order to read the original version, click here.
We’ve got trouble. Right here in Corporate Debt City. It starts with “C,” and that stands for “crash,” and that’s why I’m here.
Sound familiar? No, not the song itself—the whole song and dance. Once again, corporations and their armies of lawyers and accountants have found a loophole to take advantage of—a sweet spot that regulators have yet to regulate.
Since 2010, corporate debt of non-financial companies has risen from $3.2 trillion to more than $8.7 trillion. It’s now a record 45% of the GDP, according to Moody's. Take a moment and let those figures sink in, then think about where many of America's corporations—and our portfolios—may be headed if something doesn’t change soon. It could end up costing us even more than it did in 2008.
Digging Deeper: What’s Happening?
If you’re wondering how we got here, you’re not alone. These things have a way of sneaking up on us. Essentially, when interest rates fell to historic lows after the Great Recession, corporations were able to take on more debt while also decreasing or maintaining the cost to service that debt. It was a great time to take out a loan, as it should have been. At that point, no one was second guessing anything that promised to jumpstart our economy. The low rates were so good that they actually created an incentive for companies to borrow even if they didn’t need any cash.
Those companies—the ones that took on new debt without any plans for expansion—have instead used their additional monies to boost earnings and share prices, via corporate buybacks. According to the Economist, at least one-third of the shares being repurchased are being bought with borrowed money. And the fact that companies chose buybacks in the first place is a problem. Instead of opting to invest in technology advances like they did in the 1990s, they chose to invest in something that does nothing to bolster economic growth. And yes, I’m well aware that buybacks are great for making your balance sheets look pretty for the present moment, but creative financial engineering won’t keep any portfolio or economy strong in the long run. (You be the judge: Are buybacks basically insider trading, or do they have some good attributes?)
Lastly, the companies that took on this debt have almost been incentivized to take on more, as there’s a hefty tax deduction that comes from the interest payments. As you might imagine, companies have been in no hurry to see that perk disappear… they’re just drowning themselves in the process. Kind of reminds me of people who end up thousands of dollars into credit card debt for rewards points worth $300.
Stepping Back: What Does All This Mean?
Those of you who’ve been paying attention know that corporate buybacks were not legal prior to 1981, so we’ve been in uncharted territory there for the last 36 years. Also, as I mentioned before, the interest rates that sent corporations clamoring to the banks in 2008 had never been that low—ever. I just can’t stop thinking about how these two things will impact the financial markets in the long run, and I can’t shake the feeling that it’s not going to be good.
If you’re wondering why the use of corporate debt to purchase buybacks hasn’t been regulated, the answer lies in the newness of it all. Remember that politicians write laws to prevent past abuses from happening again. But since none of this has never happened before, we’re entering an unprecedented time in market history.
As a financial planner and economist, my job is twofold: To protect my clients’ wealth and to study the market with scrutiny, looking for both warning signs and for the next big opportunity. (Which sometimes go hand in hand.) As soon as the last recession ended, naysayers began predicting the next one, and today, dire predictions about the future of the American economy have become almost commonplace. I can’t say for certain if the corporate debt bubble is going to bring about the next crash, but I do know that the average American household—as well as the government—need corporations healthy in order to support the economy. Right now, there are a lot of sick ones that simply won’t survive when their debt comes due.
How Bad Is It?
Sit down with any financial planner, and they’ll likely tell you that growth in one’s personal wealth comes from investing for the future and reducing debt obligations. It doesn’t take a genius to know that the same logic should apply to corporate America. Yet more than one third of the world’s largest corporations currently have at least $5 in debt for every $1 in earnings—meaning that even a slight increase in the interest rate or a downturn in profits could wipe out trillions in corporate profits.
As if that weren’t scary enough, I’ve also had my eye on the slow deterioration of the U.S. credit market. Since 1980, the median bond’s rating has dropped from A to BBB-. In other words, it’s hovering just one grade above junk. Also, in the last few months, there’s been a slow-down in foreign purchases of American corporate debt. Could it be that the rest of the world sees something we don’t? Or maybe just something we don’t want to admit.
What Should I Do To Prepare?
If you’ve experienced nice gains in the last few years, that’s great, but it’s likely time to reduce your market expectations and take precautionary steps to protect what you’ve earned. If you’re working with a financial planner, you’ve probably seen a simulation of how your portfolio will perform 85% of the time. Ignore it. Seriously. You may want to take five years’ worth of your cash flow commitments out of the market. In a recession—or in retirement—your lifestyle obligations don't go away, and trouble in the markets may mean your options become limited.
Remember that gamblers never regret walking away with their winnings. At the end of the day, economics is about behavior, and while many companies may look healthy on their balance sheets, their behavior says otherwise. Now’s the time to give all your investments a closer look, and prepare, once again, for corporate America’s chickens to come home to roost.