Ever since Toy “R” Us Inc., which amassed more than $5 billion in IOUs, filed for bankruptcy last week, there’s been a growing concern that corporate America’s recent obsession with debt is in effect playing with fire. The Wall Street Journal said that corporate America has been loading up on debt and that the binge could turn into a serious problem for investors. So does the market have a Toys “R” Us problem? Not quite, but that doesn’t mean there aren’t long-term consequences to growing debt loads.
Leverage has been rising, and it’s been rising everywhere. A report earlier this month from Morgan Stanley found that debt levels have risen in nearly every industry of the investment-grade market. Even excluding mergers and acquisitions, which tend to create more debt, leverage ratios look elevated.
Net debt-to-Ebitda, a common way to measure leverage, has risen to 1.6 times for the S&P 500. That’s far less than the 6.8 leverage ratio of Toys “R” Us, but it’s still worrying. The S&P’s leverage ratio has more than doubled since 2011 and is nearly as high as it was in 2003, when the measure peaked. Ten companies in the S&P 500 have leverage ratios higher than Toys “R” Us, and 34 have leverage ratios above 5.
But the problem for Toys “R” Us, as with all bankrupt companies, was not its huge debt level but the fact that it could no longer afford it. The company last quarter had a debt-coverage ratio — its Ebitda compared with what it owned lenders — of just 1.7, meaning more than half of the cash it was generating was going to interest payments. (A figure below 1 indicates insufficient cash to cover debt.) The market doesn’t have that problem. The average coverage ratio for investment-grade companies, according to Morgan Stanley, was 10.4 at the end of the second quarter. And that’s higher than other times in which the market has struggled. Coverage ratios dipped to 8 in the run-up to the financial crisis and as low as 7 before the early 2000s recession.
A lot of this has to do with low interest rates, which have allowed companies to take on more debt without increasing their interest costs. And some critics worry that when interest rates do rise, coverage ratios will plunge. But in anticipation of that, companies have lengthened out their debt, so they may be able to maintain low interest payments long after rates go up. What’s more, the specter of higher rates has been hanging over the market for a while and still not materialized. Some economists think that demographics and structural forces will keep interest rates relatively low for much longer than before. And if President Donald Trump is able to get a tax bill passed with either a holiday or lower taxes to bring back cash from overseas, much of those returning dollars would most likely be used to pay down debt, lowering the burden on companies if rates do rise.
But the real problem of higher debt levels for investors is not that it will lead to a wave of Toys “R” Us-like bankruptcies but that it drains the cash that companies have to do the other things that boost their stock prices, earnings and by extension the economy over the long haul. Already, stock buybacks have been slipping lately, as are capital expenditures, which never really recovered after the financial crisis. Debt might not sink the stock market, but it certainly adds to the growing list of things that are sapping what has provided a lift for the last few years.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
