The pandemic has forced corporate debt higher: But is that a bad thing?

The original article was published on the Deloitte website and can be found here.

Covid-19 has been a game changer in more ways than one.

The main impact that it has had is that it has forced companies to reassess their business models. This has had a major impact on debt, as a recent report by Deloitte points out. Corporate debt has risen during Covid, is this a bad thing? In the first part of two articles, we will look at the background to this increase.

The statistics in the article are very much focused on the US. However, this is a global trend that cannot be ignored.

Expansion and stagnation
The Deloitte report points out that, before COVID-19 hit US shores, the country was experiencing the longest economic expansion on record. As it happens every time when things are going well, many economists and financial analysts began hypothesizing about what could go wrong. One of the suspects in the list of possible triggers for the next recession—none of which included a pandemic as far as we know—was the high level of corporate debt. Corporate debt was edging up since 2010 as the economy recovered from the previous recession. And by Q3 2019, outstanding debt of the nonfinancial business sector, including corporates, had reached new highs compared to the size of the economy. The pandemic then became a catalyst in pushing debt even higher.

There is, however, a fair bit of variability in debt levels among companies. Analysis of company-level data reveals that some of the largest companies, especially those in information technology, communication services, and health care, have been leading the debt binge since 2010. Fortunately, this group appears to be better placed in its ability to repay debt than its counterparts in other sectors.

The report adds that, rising debt in an expanding economy with low interest rates may not necessarily be a bad thing if companies are increasing investments as well. The data4 suggests that a sizeable share of companies is doing just that. And some of these investments may well add to productivity growth in the wider economy in the medium to long term.

Debt rose sharply in 2020 for nonfinancial businesses
At the end of 2020, the total debt outstanding for nonfinancial businesses in the United States was about US$17.7 trillion. Between 2010 and 2019, debt grew at an average annual rate of 5.5%, but in 2020, growth jumped to 9.1%. The surge in debt in 2020 was likely due to at least one of three factors. First, some businesses were forced to borrow more to keep operations running as large parts of the economy slowed or shut down. Second, some businesses had to invest in technology to support remote work, wherever possible, while others had to reconfigure workplaces to ensure social distancing in jobs that required in-person work. Finally, not all businesses were worse off due to COVID-19. Key businesses in sectors, such as information technology, health care, consumer products, and communication services, witnessed strong demand growth, a trend that is likely to sustain at least in the near to medium term. Consequently, some of these businesses are likely to have borrowed more to expand the size and array of goods and services they produce.

The report points out that, no matter the reason, rising leverage last year added to already high levels of debt that existed before the pandemic. In Q3 2019, for example, nonfinancial business debt outstanding was about 75% of GDP, the highest ever at that time. With GDP declining sharply in Q2 2020, the debt-to-GDP ratio shot up during the quarter, before going down as an economic recovery took shape in the second half of the year. But, at 82.4% at the end of 2020, overall debt relative to the size of the economy is still high even by pre-pandemic standards.

Of all the debt outstanding of nonfinancial businesses in the economy, corporates account for the largest share—about 63% in 2020. And just like total nonfinancial business sector debt, corporate debt—both the level of debt and its size relative to GDP—has been edging up since 2010. The pandemic has made it a tad worse than what it was in 2019.

Decoding the drivers of corporate debt and corporations’ ability to repay: A look at company-level data
Which companies have been driving the debt binge over the past decade and during the pandemic? How are companies placed financially to repay this debt, given the decline in economic activity last year? And have investments increased along with debt, especially last year?

The report adds that, to find answers, Deloitte looked at key financial data for the top 1,000 nonfinancial corporations by market value as of April 2021 from S&P Capital IQ.7 We first ranked companies in descending order of market value and then created five cohorts: top-10, 11–50, 51–100, 101–500, and 501–1,000. Top-10 refers to the 10 highest valued companies, 11–50 refers to the group of 40 companies that follow the top-10, and so on. We also organized the data by sector and analyzed trends in debt, ability to pay, and investments for the 10 primary sectors in which these 1,000 companies operate.

As the economy changes, so do companies that drive debt accumulation
Since 2000, total long-term debt for these 1,000 companies has grown at 9.2% on average per year to US$5.8 trillion in 2020. More debt was accumulated since 2010 compared to between 2000 and 2010. For example, between 2010 and 2019, long-term debt grew at an average annual rate of 9.7%, higher than the 8.2% rise in 2000–2010. And in line with the trend for total nonfinancial corporate debt in the economy, debt for the 1,000 companies in our research universe increased at a faster pace in 2020 (14.5%) compared to the year before (8.5%).

The report points out that analysis of the data by cohorts reveals that the top 50 companies by market value are leading the debt surge. Between 2010 and 2019, the share of the top-10 in total debt for the 1,000 companies more than doubled to 5.7%, before declining slightly last year. During this period, the share of the 11–50 cohort also went up, but at a slower pace than the top-10. This broad trend in rising shares for the 50 largest companies, taken together, has mostly been at the expense of the 51–100 cohort (figure 2). Figure 2 also reveals that a mere 5% of these 1,000 companies accounted for 30.7% of the group’s total long-term debt, much higher than what the share was 10 years back.

Three sectors—information technology, communication services, and health care—have been leading debt growth since 2010, corresponding to these sectors’ growing prominence in the wider economic and business activity. The average annual growth in long-term debt in 2010–2019 for information technology was 20.1%, and for communication services it was 13.4%. Not just that, these sectors rapidly increased their debt even during the pandemic. Rising debt for these sectors isn’t surprising given that in the top-10 cohort, four companies are from information technology, two from communication services, and one from health care. And in the 11–50 cohort, 65% of companies are from these three sectors. Even in some other sectors, such as consumer discretionary, we find the influence of technology through the presence of companies such as Amazon and Tesla. In contrast, the share of industrials and utilities in long-term debt has gone down, in line with their contribution to the wider economy. In 2020, however, industrials led debt growth with a 24.9% increase.

Robin Nicholson is a Director at Corporate-911 and is a Senior Business Rescue Practitioner