How companies became addicted to debt

> Even before the pandemic, the level of corporate leverage was beginning to cause alarm. At the end of last year, the IMF issued a striking warning: as much as $19tn of business debt in eight countries led by the US — or 40 per cent of the total — could be vulnerable if there were a “material slowdown” in the economy, a scenario that, if anything, now seems tame.

I like to think of it this way:

At present, a business that is barely-investment-grade (say, BBB-/Baa3) can borrow for a decade at just over 3%/year. A risky business that is rated as junk (i.e., below BBB-/Baa3) can borrow for a decade for as little as 6% to 7%/year. The interest payments are tax deductible, so the effective annual cost to borrow is around 2.5% for barely-investment-grade and around 5% for junk, give or take. As long as the executives think they can earn more than 2.5% to 5% per year on any money they borrow, why not borrow it? And if they can justify using borrowed money to buy back shares, keeping their stock options in-the-money, why not do it?

Many US companies in mature industries (think energy, hospitality, travel, transportation, etc.) have been doing exactly that, to the point that corporate debt is now the highest ever in relation to US GDP. And it has worked beautifully... that is, until a global pandemic suddenly cut their revenues by 10% to 20% or even more, instantly flipping those expected earnings into losses. People are no longer traveling as much, or going to restaurants as much, or going to the office as much, etc.

All of a sudden, all those businesses are losing money on all that borrowed money -- they are losing so much, in fact, that many have had to borrow even more during the pandemic to be able to continue paying interest on prior borrowing and avoid going into bankruptcy.

Obviously, a private company with hundreds of millions in stable recurring revenue shouldn't operate debt-free -- debt can be a useful tool, even if only as a rainy-day tool for situations such as the recent pandemic.

In other words, corporate debt -- and especially low-interest and covenant-free debt that is secured using recurring revenue -- seems like a capital allocation (corporate finance) tool with a set of trade-offs relative to cash and venture investment. But, how much debt is "too much"? I feel like those of us who work in software can sometimes forget that for most industries, venture capital isn't even an option, which means debt can be one of your only growth financing sources of capital -- and even for those in software, some companies are not venture-fundable but might still be debt-fundable.

It's clear that the PE firms that load up billion dollar companies with billions in debt are just playing a speculative finance and asset strip-mining game. But, it would be a shame if we invested all of this time, money, and regulation into a robust "financial capital banking sector", and we can't even rely on it for capital that businesses can use to create jobs, service customers, and smooth the rough patches in the economy.

There is a natural rate of interest in an economy. When the central bank artificially lowers interest rates you get malinvestments. This is only possible with fiat currencies because you can't print gold.

None of this would be possible if interest rates were at (say) 5% which is about the historic average, or at early 90s (double digit) levels.

This ends dramatically. I'm guessing with a less dramatic version of Zimbabwe or the Weimar republic.

I have a general rule that when we are looking at something going bad in our country, one of the things to do is look at how the issue is handled in other countries, like are they doing it better or worse, and what can we learn from that that might help us decide what to do here.

With that in mind, the article should have covered how this whole corporate debt issue is handled in other countries. Are they doing better or worse? Perhaps someone who has some knowledge here could make a comment.

- Low interest rates mean it makes no sense to simply keep cash, it's better to invest in something productive. For companies that's new projects/ideas which create jobs, for individuals that might be spending on goods to stimulate the economy or buying a house.

- High interest rates are a considered a way to reduce "risky" investments. But in reality, interest is rent seeking on capital which benefits (1) lenders/banks (2) capital holders. Cheap capital enables more projects with positive ROI (above cost of capital) to be persued. And this is good for society as it drives innovation and allocates capital to innovators instead of locking it under stagnant rent seeking. Lest you worry, this doesn't hurt capital holders, as they can instead proactively invest in companies and make the same or larger returns, but now capital is allocated by merit of the project being invested in instead of by simply who can afford it because it meets some threshold. This unlocks the "long tail" of innovation. This is what is referenced in the article: 1970s Hertz took a risky bet using debt which paid off to record profits.

- Higher interest really means higher long run inflation. If you can just let money sit in a bank, doing nothing directly productive for society, and there is suddenly more of it, prices will adjust accordingly. With low interest rates, money supply will adjust with GDP growth from innovation and prices might even be reduced by higher competition and discovery of efficiencies. As long as innovation (enabled by access to capital) stays on pace with money supply, inflation stays low.

This is of course a very optimistic way of looking at things which doesn't consider the effect of things like wage growth which has all but stopped. One could argue in a non-inflationary environment that might be ok, but this is a larger topic having to do with social mobility goals rather than just the economics.

Imagine that some industries are 'thin margin' and naturally going to be competitive, and a little prone to failing if there is a hiccup.

What 'low interest rates' do is exacerbate that quite a lot - so that only a little hiccup is needed to blow you up.

There is a really, really interesting national parallel between the fall of Spain in the 2008 crisis and this story. The 'accepted narrative' is that when the Euro came along, Spain acted 'irresponsibly' and borrowed too much. But a more careful analysis (from an FT interview no less!) showed that they actually acted rationally given the very cheap money flowing in from 'Rich Europe' at the time.

So the overarching issue is real: there's a lot of corporate debt. But it's a financing instrument like any other, it might actually make sense for companies to be leveraged to some extent. Credit runs the economy, this is a form of credit.

I think a much bigger 'meta' look at this from the FT Economists would be warranted - instead of looking at this as more of a 'corporate activity' kind of thing, look at it from an economic equilibrium perspective in terms of defining 'how much debt' is actually good, or bad, and why.

The problem is that for a long time a large proportion of companies have been paying out an increasing portion of their profits to pay off massive and ever increasing debts. They still keep paying profits to the owners, and so they have ever less left for investing in improving the company. That in turn means poor growth and being less competitive in world markets.

And even worse when the economy goes through a bad period, many thousands of companies can no longer pay their huge debts and go bankrupt, with great damage to the economy.

Somehow FT makes is look like it is some "financial engineering" fault that companies are "addicted to debt". How about letting willing debt buyers get into transaction with willing debt sellers? That simple.

Is it fair to say that pension funds are largely to blame for this? Corporations can't acquire debt if nobody offers them money. Insurance companies too, of course, but pension funds in particular are at least theoretically supposed to be protecting the workers. Hard to see how debt-funded corporations (I'll mention Uber as an egregious example) are in alignment with the interest of the workers.