Economic Blog Posted by lplresearch
Wednesday, February 3, 2021
Our latest installment in debt week for the LPL Research team is on corporate debt. On Monday in our Weekly Market Commentary: Markets Shrug Off Debt Levels, we discussed federal debt, and Tuesday we tackled household debt.
Here we share five reasons why investors should not be concerned about corporate America’s debt load.
1) Companies have plenty of cash flow to cover the debt. It’s not the amount of debt that matters so much as the cash flows that are available to service that debt. As shown in the LPL Chart of the Day, corporate net debt relative to cash flow for nonfinancial corporations was actually below average in the most recent quarterly data point (source: US Commerce Department). The most recent reading of 1.38 is below the long-term average (post-1980) of 1.65 (a lower number is better, reflecting less debt, more cash flow, or both). So while corporate leverage has increased in recent years, the amount of cash flow being generated by companies has increased as well.
2) Interest rates are likely to remain low. We expect interest rates to rise gradually in 2021 but remain at historically low levels (the midpoint of our 2021 year-end forecast for the 10-year Treasury yield is 1.5%). There’s extra slack in the labor market which should help limit wage increases—a big part of the inflation equation. International interest rates remain very low, or negative, which puts downward pressure on US interest rates by encouraging US bond purchases by international investors. And the Federal Reserve has told us they anticipate pegging their target interest rate at zero for at least the next couple of years, likely limiting the magnitude of any potential upward moves in the 10-year Treasury yield. Given relatively long maturities, a meaningful increase in Treasury yields would adversely impact corporate bonds as well. However, given our expectation for only a gradual increase in yields, we think the impact on corporate bond returns would be manageable.
“Corporations have taken advantage of low interest rates and healthy credit markets to shore up their balance sheets,” said LPL Research Chief Market Strategist Ryan Detrick. “While investors may be concerned about high debt levels, companies are generally in an excellent position to service that debt with strong cash flows.”
3) Companies have termed out their debt well beyond 2021. Corporations have pushed out debt maturities in recent years. Only an extremely small amount of corporate debt will mature in 2021 and the peak year for corporate bond maturities does not come until 2025. That means corporations will only have to service their debt, rather than pay it all back, which reduces the chances of ratings downgrades or defaults in the coming year. Moreover, interest coverage ratios (the amount of cash available to cover interest payments) have increased in recent years and are near record levels, suggesting servicing existing debt levels should not be a problem over the next few years.
4) Economic recovery is ahead of schedule. The resilient US economy is on track to see a significant pickup in growth over the balance of 2021 as the pace of vaccine distribution accelerates and the economy fully reopens. Our forecasts for US gross domestic product (GDP) growth in 2021 of 4-4.5% may prove conservative. More economic growth likely creates a better environment for companies to generate the cash flows necessary to service their debt.
5) Corporate profits are rebounding strongly. Companies have managed their businesses efficiently during the pandemic—particularly large ones—and we believe they are set up for a very strong rebound in profits and cash flows in 2021 as the economy fully recovers. Consensus sees S&P 500 earnings rising nearly 25% in 2021 (source: FactSet), and that consensus estimate has been rising during an excellent fourth quarter earnings season.
The good health of corporate America overall supports our preference for investment-grade corporate bonds over US Treasuries. However, low yields, a relatively narrow yield advantage over US Treasuries by historical standards, and interest rate risk limit the attractiveness of corporate bonds and support our preference for stocks over bonds.
IMPORTANT DISCLOSURES
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
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All index and market data from FactSet and Bloomberg.
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