Rising Levels of Debt Pose Big Problems for Investors

Companies have survived the pandemic by borrowing, putting even more strain on a longstanding issue

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Jan 06, 2021
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So far, the coronavirus pandemic's economic impact has not been as bad as initially expected on a micro-level.Thanks to the Federal Reserve and other central banks' easy money policies around the world, a much higher number of companies have been able to access enough liquidity to muddle through the crisis, even if their balance sheets were already in shambles. Many publicly-traded businesses have also been able to tap investors for additional cash. This has helped keep the lights on and financing costs low.

Of course, not every business has been successful. Countless operations in the United States and other countries have collapsed. Still, overall, the tsunami of liquidity and debt issued since the beginning of last year has helped avoid a complete economic meltdown - foe now.

Borrowing binge

Global corporate bond issuance hit $5.4 trillion last year, up 25% year-over-year. That's a conservative estimate of the amount of borrowing companies have drawn to survive. Companies also tapped the syndicated loan market for a further $3.5 trillion.

This borrowing may have sustained companies through the uncertainty of the first wave of the pandemic. Still, it has created a minefield for investors and businesses to navigate during the next few years.

Corporate rating agencies are predicting a spike in bankruptcies over the next 12 months. They expect as much as 9% of the corporate universe to hit a liquidity event by September. S&P Global warned last month that 515 companies remained on unstable footing, with finances so precarious that they could fall into bankruptcy or require a restructuring.

These warnings, coupled with the borrowing figures highlighted above, are worrying for renowned distressed debt investor

Howard Marks (Trades, Portfolio). In a recent interview with the Financial Times, he warned that many businesses are now taking on so much debt that they cannot possibly meet their obligations.

"Even borrowers that eventually are profitable may find themselves over-levered after the pandemic and struggle to service their debt," he said. The situation could become even worse if interest rates start to move higher - as they already are.

The problem of debt

Something I've always been aware of as an investor is debt and the problems debt can cause if a company takes on too much of it. Over the past decade, it has become almost fashionable to borrow as much money as possible. Companies have borrowed money for multiple reasons, including share buybacks and large acquisitions, often for the man purpose of keeping the share price moving up - and with businesses able to borrow at or near 0%, who can blame them?

Debt is not always a bad thing. Companies can use debt quite successfully. However, one always needs to be aware of borrowing and how these borrowings may impact a firm's ability to grow or even survive in the future.

Heading into the pandemic, I owned several businesses that had considerable levels of borrowing. I was comfortable with this at the time of the investments because they were generating cash to reduce debt, and the cost of the debt was low.

The pandemic changed that. Showdowns hurt cash flow, impacting the ability to repay, and while all of the businesses were able to borrow more, I sold. I concluded that my original thesis was bust as, by taking on more debt to survive, these firms had reduced their ability to navigate future issues.

That is one of the biggest problems with too much borrowing: it removes flexibility. A company that has borrowed a lot may be able to dig itself out of the hole if everything goes well, buy usually, that is a big if. Business is not predictable, and if a firm has no room for error, it may be forced to make difficult decisions.

Investors may do well by avoiding these businesses altogether. Many companies that have survived the pandemic may not be good investments after the crisis recedes due to this issue.

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