Some Context For The Explosion In Corporate Debt

Earlier this week, we brought you some excerpts and highlights from a recent Goldman note which ostensibly sought to clear up what the bank’s David Kostin called “misperceptions” about buybacks.

As noted on Wednesday, this debate is getting a bit stale for my tastes, which is ironic, because it’s the opposite of “stale” in the public domain. Enterprising politicians have seized on the buyback debate as campaign fodder and defenders of share repurchases have increasingly turned to ad hominem attacks, making it impossible to sort out who, on either side, is worth listening to.

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Goldman Wants To Talk To You About Buybacks Because You’ve Got This All Wrong, Ok?

Here’s how we put it on Wednesday:

It has become impossible to separate political grandstanding from honest criticism when it comes to demonizing buybacks. On the other side of the debate, it’s equally difficult to discern whether those who malign political grandstanding are actually interested in absolving buybacks with good arguments or are in fact just writing to express their disgust with the hyper-politicizing of the debate in general. The former is a worthwhile enterprise, while the latter is tantamount to saying nothing, because in today’s America, every issue is hyper-politicized.

Those interested in reading more on why Goldman’s Kostin believes the furor over share repurchases may have become at least somewhat detached from reality are encouraged to check out the above-linked post.

On Friday, while perusing a new Goldman note on corporate leverage, we found a bit more incremental color which, while not necessarily “profound” is still worth mentioning in the context of this debate.

Specifically, the bank set out to “explain” an apparent disconnect between the well-documented surge in non-financial corporate debt and the corporate sector financial balance, which is just the gap between total income and spending.

As Goldman writes, “corporate debt as a share of GDP has grown steadily since 2011, leading to concerns about macroeconomic risks posed by higher leverage [but] at the same time, the corporate sector financial balance looks healthy as it is positive and remains above its historic average.” Here are two visuals:

(Goldman)

Again, what you’re looking at over there in the right pane is the sum of net income and depreciation minus capex and dividends. On the surface anyway, it might seem odd that the corporate sector continues to pile up debt despite a relative healthy financial balance.

“The financial balance is a measure of flows, while debt outstanding is a stock measure, and positive financial balances might suggest little need to issue additional debt and increase the stock of total debt”, Goldman goes on to write, zeroing in on the apparent quandary.

Well, as you might imagine, the answer lies in capital structure choices and, more specifically, in a shift away from equity in favor of debt. “Since share buybacks were explicitly permitted by the SEC in 1982, equity repurchases, net of equity issuance, have been correlated with debt issuance”, Goldman continues.

As it turns out, when you look at the size of the corporate sector’s financial balance in 2018 (~1.2% of GDP) and you add net debt issuance (~1.3% of GDP), you end up with “the amount of funds used to repurchase equity” at 2.5% of GDP.

(Goldman)

Obviously, low rates incentivize financial engineering, although a word search of Goldman’s note for “engineering” doesn’t turn up anything, as they prefer to employ less derisive language. To wit:

This positive link between debt issuance and share repurchases is being driven by interest rates and equity valuations. Low interest rates, or low equity valuations, incentivize corporates to issue more debt and repurchase equity. In statistical models, we find that lower credit spreads are associated with both more net debt issuance and greater net repurchases of equity, controlling for current investment and the state of the economic cycle.

Ok, so no surprises there. The pressing question (and “pressing” is probably an insufficient adjective when it comes to communicating the concerns of those who are worried about elevated corporate leverage) question, though, is whether a sudden deterioration in market conditions (i.e., if they cycle suddenly turns and the US economy were to careen into a downturn), could force a highly-leveraged corporate America to make deep cuts to investment.

For Goldman, the above-mentioned financial balance offers some good news on that front.

“We view the corporate sector financial balance as a good gauge of this risk, because it effectively measures how dependent corporate investment is on external funding”, the bank writes, adding that “a positive financial balance implies that profits are high relative to investment and that investment is therefore less dependent on external finance.”

There’s good news and bad news there – or at least that’s the way I read it. The good news is that in the event of a recession, corporates may not have to slash investment thanks to a wide gap between profit growth and capex growth. The bad news is, that gap would appear to suggest that corporates haven’t been investing “enough”, where “enough” is admittedly subjective.

(Goldman)

Goldman goes on to warn that while the above theoretically suggests that in a downturn, management teams could simply eschew buybacks in the interest of making sure investment doesn’t crater, that could end up undercutting confidence in a market where buybacks have served as a kind of real-life plunge protection. To wit:

While positive financial balances do suggest that the corporate sector could reduce equity repurchases rather than investment in the face of credit market disruptions, fewer share buybacks could be viewed unfavorably by equity markets and therefore lead to a broader tightening of financial conditions.

That excerpt should be juxtaposed with the following quote from Kostin (found in the buyback “misperceptions” piece cited here on Wednesday):

When earnings drop sharply, managements can easily reduce the cash spent on buybacks without disrupting dividend policy. Investors expect steady growth in regular dividends and do not take kindly to firms that cut dividends per share.

Finally, in their Friday note, Goldman acknowledges the self-evident risk in rising corporate leverage which is that if rates rise and/or spreads widen, interest expense jumps and profits get squeezed, laudable/mitigating efforts to extend maturity profiles notwithstanding.

So, there you go. Some further color that will invariably be met with yawns coming as it does on a Friday.

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