Corporate Debt Drags on Economy

A new wave of corporate bankruptcies is reminding workers and investors that the fallout from the recession isn’t over.

A major problem remains with the huge debt load U.S. companies took on during the late 1990s. In some industries--particularly telecommunications--the debt mania at its peak rivaled the stock mania in the dot-com sector.

Corporations, excluding banks and other financial companies, have more than $4.9 trillion in bond and bank debt, up a trillion dollars just since 1998. Now, some analysts believe high corporate debt could keep any economic recovery in low gear for the next few years.

“Unless you see a rapid turnaround in profit growth, [many companies] are going to be financially strapped” by debt, said Paul Kasriel, economist at Northern Trust Securities in Chicago. That, in turn, could limit businesses’ ability to spend on new equipment or on workers.

Even as key economic indicators suggest a rebound, the failures in recent weeks of Enron Corp., Kmart Corp. and Global Crossing Ltd., among others, have pointed up the threat companies still face from heavy debt burdens.

The boom times of the late 1990s encouraged companies to borrow aggressively, particularly via long-term bonds.

The total amount of corporate bond debt outstanding rose just 25% from the end of 1990 to the end of 1994, according to credit-rating firm Moody’s Investors Service. But as the economy grew rapidly from 1995 to 1999, corporate bond debt rocketed 125%, to $2.59 trillion by the end of 1999, Moody’s said.

Perhaps more striking, even as the economy slowed in 2000 and 2001, corporate bond debt continued to grow, reaching $3.39 trillion by the end of last year, according to Moody’s.

Most of those corporate borrowers continue to pay their lenders the interest they’re owed, and aren’t in danger of insolvency. Still, the interest costs that companies bear have helped cause a plunge in corporate earnings over the last year that has been far more severe than the modest decline in U.S. gross domestic product would imply.

For example, paper and forest products giant International Paper Co. borrowed heavily in recent years to acquire several major rivals. The deals have nearly doubled the company’s long-term debt burden since 1996, to $13.3 billion now. The company’s interest bill on its debt totaled $929 million last year, which helped to reduce its net income for the year to $214 million, a 78% drop from 2000.

Of course, debt often serves a useful purpose, analysts note. Just as a mortgage allows a family to buy a home that may appreciate in value in the long run, bonds allow companies to make investments that ultimately may produce generous returns for shareholders.

But debt costs that seemed manageable in an economic boom quickly can become onerous in an economic bust, as companies’ sales and earnings decline--and in some cases their assets, as well-- while their debt expense stays level.

“Debt only becomes a problem when a company isn’t generating enough cash flow to meet” interest and principal payments, said John Lonski, economist at Moody’s in New York.

That predicament has befallen many more companies over the last year, resulting in the highest rate of bond defaults--missed interest payments--in a decade.

Moody’s said 253 companies worldwide defaulted on $110.2 billion of bonds last year, compared with 167 companies defaulting on $49.2 billion of bonds in 2000.

The firm expects defaults to continue to rise in the first half of this year, even if the economy grows.

Indeed, January saw a record 41 companies default, according to Standard & Poor’s, another debt-rating firm. For example, Houston-based Kaiser Aluminum Corp., the nation’s second-largest aluminum company, last week missed a 25.5-million interest payment due some of its bondholders.

The number of U.S. public companies filing for bankruptcy protection topped 240 last year, according to the Boston-based Turnaround Letter. The companies listed total assets of more than $250 billion, by far a one-year record.

Historically, it isn’t unusual for corporate failures to continue to rise at the start of an economic recovery, as companies that had been barely hanging on find they can’t keep going. The question is whether this time will be worse because of the level of debt.

Some analysts worry that the Federal Reserve, in slashing short-term borrowing costs to 40-year lows, is in effect supporting many companies that ought to be allowed to fail--or that at least should be encouraged to shed debt.

“Usually recessions are a time when you repair your balance sheet,” Kasriel said. But he fears that too few companies have taken meaningful steps in that direction, which could mean prolonging the process of weeding out weak firms.

Others argue the financial system is in fact repairing itself. Given the rise in bond defaults and bankruptcies over the last year, “it seems to me the adjustments are taking place,” said William Dudley, economist at brokerage Goldman Sachs & Co. in New York.

Dudley and others also note that the continuing surge in bond issuance last year in part reflected companies’ refinancing of older, higher-cost debt at lower yields, just as many households refinanced their mortgages to save money as market interest rates dropped.

In some debt-heavy industries, however, market forces have adopted a take-no-prisoners approach to troubled borrowers.

Perhaps no sector has been as hard-hit by debt woes as the telecommunications industry. Beverly Hills-based Global Crossing, which operates a worldwide fiber optic network, became the largest telecom-company bankruptcy when it sought court protection on Jan. 28.

But Global Crossing is just another in a lengthening queue of telecom firms to go belly-up. It was followed last week by McLeodUSA Inc., a Cedar Rapids, Iowa-based telephone company.

Telecom companies borrowed tens of billions of dollars in the bond market in the late 1990s to build new networks. But it represented massive overkill: The marketplace has been able to absorb only a small portion of the new network infrastructure.

With no possibility of profit on the horizon, and their funding cut off, dozens of telecom companies have failed over the last year, leaving bondholders holding the bag.

Just as with dot-com stocks, the question asked today is why investors were such poor judges of the telecom firms they funded.

“It’s actually laughable how that money was allocated” to telecom companies, said one institutional investor. He noted that bond investors are expected to be savvier and more risk-conscious than stock investors.

Some analysts say bond offerings in general were an easy sell in the late ‘90s because the stock market’s record gains sent such a bullish message to investors overall: the idea that recession was a thing of the past, and that economic growth could continue forever.

“Bond investors believed what the equity market told them,” said Moody’s Lonski.

Fed Chairman Alan Greenspan is criticized by some for appearing to egg-on both the stock and bond markets with many comments in the late ‘90s about a “new economy” and about the perceived benefits of companies’ heavy investments in new technology.

Barton Biggs, investment strategist at brokerage Morgan Stanley in New York, says Greenspan “provided the high-octane fuel, both intellectual and monetary, that transformed a ‘healthy’ bull market and a ‘normal’ expansion into the most gigantic boom and bubble of all time.”

But one use of debt that Greenspan did not champion outright in the late ‘90s nonetheless became standard at many companies: borrowing to fund share repurchases.

“A lot of companies issued debt not to buy capital goods but to buy back their own stock--and at high prices,” Kasriel said.

The motivation was to boost reported per-share earnings. As a company retired stock, net income was spread over fewer shares, instantly juicing growth rates.

But those earnings gains are history, while the debt issued to fund the buybacks is still on corporate balance sheets, and must be serviced.

Despite the rising number of corporate bond defaults over the last year, the vast majority of companies will continue to pay their debt bills, analysts say. The bigger issue is how great a weight the debt will be in terms of limiting companies in other spending.

“If companies are so heavily indebted that they can’t adopt new technologies, they’re going to have a problem” long term, Lonski said.

That also could keep the economy as a whole from getting back on a strong growth track soon, Lonski and others said.