Companies are stockpiling debt for all the wrong reasons

The corporate debt bubble has become an overriding worry on Wall Street in 2019.

By a number of measures, corporate debt has hit historically elevated levels.

When compared with corporate profits, which have also skyrocketed, the picture is far less frightening.

But an overlooked concern is how massive stockpile of debt is being used, which is primarily for acquisitions and to pay off via dividends and buybacks.

This is potentially a problem when a recession strikes, as companies will have less flexibility to borrow, limiting new projects and investments they can fund and ultimately the company's growth prospects.

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Corporate debt has become the concern du jour among Wall Street elite in 2019.

The corporate credit load was a hot topic at Davos in January.

It was a similar story at the Milken Institute Global Conference in April, where the brightest minds in finance fretted over the $3.8 trillion in investment grade bonds in the US that are on the precipice of slipping into junk status.

And in May the Federal Reserve sounded the alarm on the ocean of risky corporate debt, which now eclipses financial-crisis levels.

We're not yet in crisis though — not even close judging by the broader economic health — and concerns over whether corporate debt will send us there may be overstated at this point, according to article this week from the Federal Reserve Bank of New York.

An overlooked danger is the implications of how companies are using that debt, and why it could imperil them when a recession inevitably does arrive.

The broader debt stockpiling does look scary. Corporate debt in the US is at a 50-year high, when compared to GDP levels.

But thanks to the robust economic recovery, corporate profits are also soaring. The higher your cash flow, the more you can sustainably borrow without putting yourself in danger.

“Although corporate debt has soared, concerns about debt growth are mitigated in part by higher corporate cash flows,” the Fed wrote in the report.

When weighted against corporate profits, the scenario looks a lot less nerve-wracking:

The chart above essentially shows that even though debt-to-GDP is at a 50-year high, when you divide that debt by companies' profits we're actually well-below historical peaks, and the ratio has been falling since 2016.

This doesn't mean we're off the hook, though. Aggregate data, while helpful, can be misleading.

As the Fed put it, an economy comprised entirely of companies with moderate debt levels is more impervious to shocks than a company where half the companies are debt free and half the companies are highly leveraged — even if the aggregate figure is identical.

When you break down debt-to-cash flow for the 3,000 largest US companies, the debt burden among the weakest has ramped up since the crisis, but has been declining in recent years.

A perhaps underappreciated concern is what these companies are doing with all the money they're borrowing. In short: they're not investing in capital projects to grow their businesses and hire more people, but rather are primarily buying up other companies and handing out cash to investors.

The above chart — weighted by assets to account for the disparity in company size — shows that debt increases are associated far more with M&A, dividends, and buybacks than capital investment.

Why does this matter？

It can create a “debt overhang problem,” the Fed explained, in which companies have no flexibility to raise more cash to fund new projects, handicapping a company's growth prospects.

In other words, if you've borrowed a bunch of money to hand it over to investors in the short term, and then a recession strikes, you may not be able to borrow any more money since your profits are earmarked to pay off your existing creditors.

In addition to cramping a firm's financial flexibility, it hurts investors in the long-term and has knock-on effects for the broader economy, which sees less growth and less projects and less jobs to staff those projects.

Moreover, in a dire economic scenario, a highly leveraged company may struggle to pay off those creditors at all and slide into bankruptcy. Doing that for the sake of paying off investors in the short-term — as opposed to funding organic growth and new projects — may be viewed less favorably, and it also may result in less tangible value to work with to clean up the mess.