Investment Insights

Top of the Cycle US Corporate Balance Sheets

Top-of-the-Cycle U.S. Corporate Balance Sheets

March 2015

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BNY Mellon Chief Global Markets Strategist Jack Malvey and team explain why they believe there’s nothing wrong with record corporate debt and equity valuations.

Supporting Credit Spread Stability and Further Equity Valuation Life

  • U.S. corporate balance sheets in early 2015 are the strongest since 2006 on a market-value weighted basis.1
  • Total corporate debt has fallen to 25.1% from 34% at the time of the global financial crisis.2
  • Stronger corporate balance sheets support the possibility of stable investment-grade and high-yield corporate bond credit spreads and further advances in corporate equity valuations.

Various metrics track aggregate and individual firm corporate financial leverage. The standard approach relies on book value: just use the tallies on the balance sheet.

This conventional methodology will never vanish. But the early proselytizers of the modern high-yield corporate bond market in the 1980s widely convinced credit market disciples to also consider a market-weighted approach. To take a hypothetical example, suppose two firms each have $500 million of corporate debt and corporate equity on a book value basis. But on a market value basis, firm A’s debt trades at 90 cents on the dollar ($450 million) and its equity at $300 million. In contrast, firm B’s debt and equity trade at $550 million apiece. Under this methodology, which firm would be presumably less risky for an investor? Answer: naturally firm B.

In a similar and imperfect manner, aggregate corporate market-weighted capitalization can be constructed. This calculus has several caveats. Corporate debt indices from Barclays are used to generate bond market valuations. But these rules-based indices do not include all corporate debt components, like debt with less-than-one-year to maturity.

Despite these caveats, this capitalization data is instructive on a time series basis in our view.

For corporate America, the great recession of 2007-2009 has long been over. Indeed, U.S. corporate balance sheets in early 2015 are the strongest since 2006 on a market-value weighted basis.1

As shown in Figure 1, total debt has fallen from 34.0% in 2008 (36.4% in 1974 all-time peak since inception of our series in 1973) to the current 25.1%.2 This improvement in financial leverage has come about despite the record spurts in investment-grade and high-yield corporate bond supply over 2009-2015 as well as the appreciation of debt values as interest rates generally declined.

This market-based estimate of trimmer corporate financial leverage mainly has been powered by the huge rally in equity capitalization from $12.9 trillion in 2008 to $30.6 trillion in February 2015.3 And anxious issuers seeking to reduce their dependence upon the potentially non-continuous supply of liquidity in the short-term capital markets have cut their commercial paper outstanding nearly in half from a peak of nearly $2 trillion in 2006 to about $1 trillion in February 2015.4

The top-of-the-cycle U.S. economic engine is firing on all cylinders for corporations. We believe there’s nothing wrong with record corporate debt and equity valuations.

BNY Mellon Investment Management

In our view, the strengthening of American corporate balance sheets supports continued credit spread stability across the investment-grade and high-yield corporate bond markets. And this metric suggests further appreciation potential for equity valuations.

In our opinion, this detailed data series provides several additional useful insights:

  • Commercial paper’s share of U.S. corporate capitalization (2.5%) is 4% below the 1973-2015 mean of 6.5% and the lowest in the history of this series. Issuers are not only willfully becoming less dependent on short-term paper and hoarding cash to defend their liquidity but are also intentionally moving out the curve to lock in historically low interest rates
  • From a 42-year mean of 9.7% from 1973 to 2015, commercial & industrial (C&I) loans have shrunk to 4.4% of capitalization. Back in 1974 when the disintermediation of corporate borrowing from commercial banks to the security markets began to become fashionable, the C&I share of corporate capitalization peaked at 19.5%. Although currently a record $1.8 trillion, the C&I capitalization share has been fairly consistent in the low 4% to 6% neighborhood for much of the last two decades
  • In contrast to commercial paper and C&I loans, fixed-rate corporate debt placed in the public security markets has gained capitalization market share. Investment-grade corporate debt of $4.2 trillion in February 2015 represents 10.3% of corporate capitalization versus the long-term average of 9.5%. 144As have climbed to $1.3 trillion and a 3.2% market share. High-yield corporate debt also has increased to almost $1.4 trillion and 3.4% market share.1
  • With interest rates so low, corporate floating-rate debt has become almost an endangered species. Down to $307 billion and only a 0.8% market share currently, FRNs were $651 billion and 2.4% of corporate capitalization as recently as 2007.
  • Convertibles also tailed off from $345 billion (1.3% market share in 2007) to just $229 billion (0.6% market share) in February 2015.

These long-term series point to the possibility of additional improvement ahead in the composite balance sheet of corporate America. In a positive feedback loop, such robust balance sheet health supports further advances in corporate equity valuations. The top-of-the-cycle U.S. economic engine is firing on all cylinders for corporations. We believe there’s nothing wrong with record corporate debt and equity valuations.

 

The views and opinions expressed herein are solely those of the Center for Global Investment & Market Intelligence and do not necessarily represent those of other BNY Mellon entities.

1 U.S. commercial paper outstanding (1973 to 2015) from Bloomberg, Commercial and Industrial Loans Outstanding (1973 to 2015) from FactSet, Barclays U.S. IG Corporate Index (1973 to 2015) from BarclaysLive, Barclays 144A Index (1997 to 2015) from BarclaysLive, U.S. Corporate FRNs (2003 to 2015) from BarclaysLive, Barclays Corporate High-Yield Index (1987 to 2015) from BarclaysLive, Barclays U.S. Convertibles Index (2002 to 2015) from BarclaysLive, Market value of domestic corporate equities including common and preferred shares (1973 to 2015) from Federal Reserve and Bloomberg. U.S. corporate debt measured as a sum of Commercial Paper outstanding, Commercial and Industrial Loans outstanding, Barclays U.S. Investment Grade Corporate Index, Barclays 144A Investment Grade Index, U.S. Corporate FRNs, Barclays Corporate High-Yield Index, and Barclays U.S. Convertibles Index.

2 U.S. corporate debt measured as a sum of commercial paper outstanding, commercial and industrial Loans outstanding, Barclays U.S. Investment Grade Corporate Index, Barclays 144A Investment Grade Index, Barclays U.S. Corporate FRNs, Barclays Corporate High-Yield Index, and Barclays U.S. Convertibles Index.

3 Equity capitalization measured as market value of domestic corporate equities including common and preferred shares.

4 Measured as dollar amount of commercial paper outstanding.

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