Debt-Boom Days May Be Over, Market Experts Say : News Analysis

The resounding stock market selloff is the latest and most vivid sign that corporate America’s love affair with debt finally may have gone too far.

Corporate debt in recent years has grown to the highest levels in the post-war period. Corporations have increasingly favored debt--in the form of bonds or bank borrowings--over the issuance of stock as a means of raising capital. A growing portion of corporations’ cash income is being used to pay interest on debt. The surge in corporate takeovers in recent years was financed heavily by debt in lieu of buyers spending cash from their own pockets.

Some of that debt has helped to propel the long-lasting economic expansion and bull market of the 1980s as companies have added facilities, equipment and jobs at an impressive clip.

But the debt binge also has brought on a deterioration in the financial strength of many corporations. Bond defaults are rising; bond safety ratings are falling.

“All in all, the 1980s are to debt what the 1960s were to sex,” writesJames Grant, editor of Grant’s Interest Rate Observer newsletter in New York and a leading critic of the corporate debt boom.

The total level of debt alone wasn’t enough to trigger Friday’s devastating 190-point plunge in the Dow Jones industrial average.

Most corporate debt appears to be fairly safe. Much of it is owed by companies in such stable industries as food processing or other consumer-oriented enterprises where revenues and profits are reasonably stable, even in recessions. That gives them the ability to handle high debt payments during hard times.

But there is concern that companies in “cyclical” industries such as transportation, retailing and financial services have accounted for a greater share of the corporate debt burden. These industries are most vulnerable to an economic downturn because their revenues and profits can decline sharply, making high debt payments a painful obligation. The value of their assets also could fall, leaving them unable to rescue themselves by quickly auctioning off subsidiaries, divisions or real estate.

That partly explains why the news on Friday that bank financing had fallen through for a $6.75-billion management-led buyout of United Airlines’ parent company, UAL Corp., ultimately helped trigger the market’s free-fall. Stocks of UAL and other takeover candidates had been driven up on speculation that lenders would continue to finance them.

Adding to the pessimism were forecasts of shrinking corporate profits and repeated disclosures in recent weeks of debt troubles and bond defaults at several well-known businesses in transportation, retailing and financial services. Many of these companies--the hardest hit including Campeau Corp., owner of several major department store chains, and Integrated Resources, a major financial services concern--previously had issued high-risk, high-yield junk bonds. Their troubles sent the $200-billion junk bond market into its own crash in recent weeks.

Even before the latest junk bond jitters, Michael Milken, founder of the modern junk bond market, lately has been urging corporations to use more stock rather than junk bonds to raise capital. With interest rates on junk bonds as high as 15%, or even higher, but stocks at near record prices, firms would be better off issuing stock rather than junk bonds, Milken reasoned.

“The market is telling companies to use more equity now instead of debt,” Milken told The Times recently.

Corporations also incur far less risk when they issue stock rather than bonds, in part, because the only financial burden of stock is the payment of dividends, which a company can unilaterally halt in a cash crunch without risk that shareholders will lay claim to the corporation’s assets.

If companies begin turning more to stock rather than debt for their financing, it would reverse the greatest corporate debt binge of modern times--a trend that was driven, in part, by the tax deductibility of interest payments.

Overall, non-financial corporations in this decade have piled on almost $1 trillion in debt while retiring nearly $500 billion in stock through corporate takeovers, buyouts and other measures.

Interest payments now absorb nearly 30% of corporations’ cash flow (cash income from operations before expenses), up from less than 20% at the beginning of this decade. Corporate debt as a percentage of companies’ net worth (assets minus liabilities) has ballooned to 83.8% from only 51.4% in 1980.

Debt mania has not been without its benefits.

Companies with higher debts until now generally have grown faster and outperformed those with low debts, and their stock prices have risen accordingly, said Stephen L. Nesbitt, vice president at Wilshire Associates, a Santa Monica investment research and consulting firm.

“Without the increased debt, stock prices wouldn’t be as high as they are,” Nesbitt says.

The worry now is that debt has gotten too big and economic conditions that made high debt levels safe and smart in the 1980s may no longer apply.

“Debt is like chocolate cake, it’s wonderful by the plateful but by the van load it can do bad things to your skin,” says newsletter editor Grant.

Already, debt growth has led to a deterioration in the creditworthiness of American corporations. Bond-rating firms such as Moody’s Investor Services and Standard & Poor’s have lowered ratings on more corporate bond offerings than they have raised in recent years. A fewer percentage of bonds wins the highest ratings, while junk bonds--the lowest-rated corporate bonds--now account for 24.4% of all issues rated by Moody’s, compared to only 6.8% at the end of 1981, said Moody’s senior economist John Lonski.

Bond defaults have ballooned in recent months. Campeau defaulted amid a cash crunch and disclosed that it is selling the venerable Bloomingdale’s department store chain. Resorts International Inc., the hotel-casino company bought by Hollywood producer Merv Griffin, proposed a sweeping overhaul of its debt commitments. L. J. Hooker, owner of the Bonwit Teller and B. Altman & Co. retail chains, filed for bankruptcy after it could not make payments on $1.2-billion of debt.

Such incidents have highlighted how debt-laden companies can be weakened even without a recession. The burden of heavy debt payments may force companies to scale back spending on new stores or factories, capital equipment, research and development or other needs vital to stay competitive, some experts say. Airlines, for example, may have to curb purchases of new aircraft, and some regulators are concerned that debt burdens could jeopardize airline safety.

Some debt-laden firms also are more vulnerable to a challenge by competitors. Albertson’s, a supermarket and drugstore chain with relatively little debt, plans to double its store expansion rate in Southern California in hopes of taking market share away from debt-heavy rivals such as Vons, Ralphs (owned by troubled Campeau) and Lucky. High debt at supermarket chains could be an additional risk because their profit margins are very small, said Moody’s economist Lonski.

High debt also means that companies that aren’t competitive are on a razor’s edge, with less time to catch up.

Such has been the case with Western Union, once an innovative communications company that saw its telex business hammered by the growth of facsimile machines. It took on high debt to try to stay competitive but now is seeking to restructure part of its $1-billion in long-term debt, including $500 million in junk bonds on which it currently is paying a whopping 19 1/4% interest rate.

The small margin for error has also hurt Integrated Resources, the New York financial services firm that defaulted in July on nearly $1 billion of debt. The company had been a major marketer of tax shelters, but the Tax Reform Act of 1986 killed that market, forcing Integrated to reshape itself as a seller of insurance, mutual funds and other products. But critical management mistakes and simple overborrowing prompted the firm’s recent decision to sell most of its key businesses.

But some analysts argue that high debt woes do not necessarily signal a recession or widespread bankruptcies, noting that most corporate debt is still with companies better able to handle the payments.

Between 1982 and 1988, 75% of the growth in corporate interest payments has been concentrated in three relatively stable segments of the economy: public utilities, services and nondurable manufacturing such as food, tobacco and apparel, said Stephen S. Roach, senior economist at the investment banking firm of Morgan Stanley & Co.

“We have pushed the limits of leverage a bit . . . but even in a recession scenario, I don’t believe we’ll see a wave of bankruptcies,” says Marko Budgyk, a vice president at Houlihan, Lokey, Howard & Zukin, a Los Angeles investment analysis firm. “Most debt-laden companies are well suited to withstand a recession.”

RJR Nabisco, for example, incurred the biggest one-time debt increase of all--a stunning $26 billion--when it was taken over earlier this year by Kohlberg Kravis Roberts & Co. in a leveraged buyout. But RJR’s businesses, primarily in cigarettes and food products, are relatively recession-proof, analysts maintain.

Many cyclical industries, such as autos, steel and capital machinery manufacturers, have avoided piling on huge debt, said Nesbitt of Wilshire Associates. The same has been true generally for some industries, such as computers and other high-technology enterprises, that require substantial research and development expenditures.

Some cyclical industries, such as energy, have even reduced debt burdens and are enjoying higher overall bond ratings, Moody’s Lonski notes.

These and other companies may have learned their lesson from the recession of 1980-82--the worst since the Great Depression--when companies with high cash and low debt were better able to withstand the economic hurricane.

“The debt situation does not look as disastrous as the macro numbers might suggest,” Nesbitt says. “Of course,” he adds, “there will always be companies that go overboard.”

But even for some that do go overboard, the potential damage may be limited, he contended.

Companies such as Campeau with debt troubles may not necessarily go out of business, but rather will continue operating on a smaller scale while selling stores or other assets to stronger and better managed companies. Jobs may not necessarily be lost in the transition.

“Campeau is a situation where no one wants to shut it down. It has tremendous value but just took on too much debt” because of overly optimistic revenue forecasts, Nesbitt said.

Other companies may become more focused on lines of businesses they know best. Borg-Warner, for example, incurred high debt but has sold off a number of divisions and has shrunk back to the business of transportation equipment, noted A. Gary Shilling, a New York economic consultant.

Companies with high debt also may become better managed and more efficient, because the burden of debt payments forces managements to become more disciplined and less wasteful. Layoffs in such cases often affect middle managers, not production workers.

“Employees up and down the line are under more pressure to produce,” Nesbitt says. “But maybe that’s good.”