$3 Trillion in Corporate Debt Set to Weigh Down Stocks

Stocks

We will be seeing a huge amount of corporate debt maturing soon, with $3.3 trillion of it coming due over the next 5 years. How much should we worry about all of this?

Companies obtain financing for their businesses through one of two ways, they can either attract investment through issuing shares or they may borrow the money from banks or by issuing debt instruments such as corporate bonds.

Issuing shares is called equity and loans or bonds is classified as issuing debt. As for equity financing, a public company only gets paid when new shares are issued. Beyond that, these issued public shares get traded between parties on secondary markets, with the price depending on the dynamic between how much people want to pay for the stock and how much the current stockholders who are willing to sell their stake are asking for it.

While companies do not earn any revenue from the further trading of their shares beyond what they collect when the stock is first issued, stock prices do matter to them, the ownership of the company at least, which are the shareholders. We could say that the shareholders are essentially the company though, and movements up or down will increase or decrease the value of everyone’s portion of the company.

Companies don’t really owe money to shareholders, the way that they would owe money they borrowed, but this equity can become expanded or contracted by way of a company’s market operations. They may issue new shares, which raise money for the company but dilute everyone’s equity, although the money goes back into the company so theoretically share value should not change here.

To use a simple example, let’s say that a company has a million shares outstanding, and this number doesn’t matter, which are currently valued at $100 per share. They issue 100,000 new shares, and if there were no reciprocal effect on the company’s value, this would dilute the value of these million shares. There are now 1.1 million shares out there and the company’s value needs to increase accordingly so that the value of each doesn’t go down.

The new stock provides an influx of capital though, which gets added to the company’s value, and therefore this share dilution gets offset. If the company uses this money wisely, this can present an opportunity for expansion, increasing earnings and future share value.

Companies also borrow money, which requires them to pay interest, although the intention is to earn a profit net of these interest payments by investing this borrowed money into the company. Equity financing, on the other hand, is interest free since nothing is being borrowed or needs to be paid back, but there are still limitations on how many new shares you can issue efficiently, and companies rely on both means to raise money.

When they show a profit, this profit is both used to pay off borrowed money, the principal plus accrued interest, and what is left is either re-invested in the company or paid out. While this money may also be used to expand the business, there are also limitations on this and companies need to have good opportunities with reasonable profit expectations to make sense of spending on expansion.

Money that is not used to pay back debt and not re-invested then either gets paid out in dividends or is used to buy back stock, which pays it out to shareholders indirectly. Buying back stock has been particularly popular over the last few years, and what this does is use the money to enrich the value of the shares left outstanding.

Borrowing to Buy Back Stock Isn’t as Sweet a Deal

This money is shareholder’s money to keep, either to have it paid out or to essentially re-invest it in the company’s stock. In our scenario, we reduce the outstanding shares from a million to 900,000, which means that the value of each of these 900,000 shares will be worth more, in theory anyway.

Shareholders have therefore decided to let their profits ride so to speak, and use them to increase the value of the shares that they have, a profit that is to be cashed in later once their shares are sold. This doesn’t really require this extra value to be maintained, as regardless of what happens, if we increase the share value from $50 to $55 from this for instance, even if share prices go down, they will be worth $5 more than if this was not done.

Companies traditionally use profits for buybacks, but during the recent low interest rate environment, we have seen a lot more borrowing by companies to buy back stock. This is riskier, as well as more expensive, because if interest rates rise, this will cost the company more in interest payments and dilute their business performance accordingly.

When we view the future outlook for a company, we look at both their revenue potential and their earnings potential, and earnings involve revenue less expenses. These interest payments come right off the top, and the cost of this going up directly impacts future earnings outlook.

Whether or not this is a wise move overall, we’re left with a scenario on the horizon that has real potential to affect the bottom line of these companies. If a company issues a bond and turns around and buys shares back with the proceeds, both the interest and the principal must be paid back. While a company can pay back loans from bonds by issuing new ones, like the government does, if interest rates are rising, these new bonds will be more expensive to maintain.

Heartland Advisors Sound the Alarm

Due to the big increase in these operations over the last few years, we’re now facing a wall of corporate debt on the horizon, to the tune of $3.3 trillion of it maturing in the next 5 years. That’s almost half of all corporate debt hitting us in a very short period of time, and this is leaving some analysts, like Will Nasgovitz of Heartland Advisors, quite concerned.

Corporate bonds are issued in terms of various lengths, from short to very long-term, and ideally, we spread this out more evenly over time, and not have so much of this coming due so soon, and especially seeing so much mature where interest rates have gone up and may go higher.

Nasgovitz remarks that “while we currently don’t see signs of a full-blown financial crisis on the horizon, we do believe that excessive debt adds unnecessary challenges to companies in general and will likely be a headwind for heavy borrowers in the intermediate term going forward.”

Nasgovitz does see this as a big enough issue to substantially shape his recommendations. “Not surprisingly, our long-held caution toward financial leverage plays out in our investment decisions: our portfolios are underweight debt-laden companies relative to their benchmarks.”

That sure suggests that this is being weighted very heavily, if that’s the driving force behind their investment decisions.

These things do indeed have the potential to drag down the performance of companies who have a lot of debt maturing, but it’s not that these situations aren’t manageable providing that overall performance is maintained. These extra costs of doing business will find its way into a company’s bottom line though.

While we already know about all of this and have essentially already priced this in to current stock values, as something becomes more transparent, as more investors become more concerned about it, this can increase the effect of such a variable.

Putting this much importance on this looming debt, in other words building your portfolio around this one thing, may lie on the fringes, but this does not mean that we should just ignore the view. There’s no question that this does matter, and its impact, whether it be very meaningful or not so much, is where the crux of the argument lies.

This is nothing like a coming financial tsunami that some people fear, and this is not going to hit us by surprise either. Whatever negative effects, based upon what we know about this, has already been fleshed out for the most part, and it’s not that we wake up one day and look outside and shockingly see a giant $3.3 trillion wall of water heading for us.

It’s more like we know that the water level will be rising here, and things like this bring us down somewhat, but the outlook that we have is already being accounted for. There may be some changes in this scenario, for instance companies seeing their profits drop and having more difficulty with such debt, but these are changing business conditions, not changing debt ones.

Perhaps companies have been too aggressive with these buybacks and should exercise more prudence going forward, and there will be a price to pay for this, but probably not anything that we really need to be that afraid of.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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