Joint stock company is the bedrock of modern Capitalist society. A joint stock company is owned by a large pool of shareholders and the Board of Directors elected by the shareholders look after shareholder interest. There is an independent management which looks after the day to day working of the company.
To align the interest of the management with the shareholders, many a times their remuneration i.e. bonus etc is tied to the performance of the company’s share price and they are also given ESOPs (Employee Stock Options – shares of the company)
Thus, it is in the interest of the management to do everything to keep the share price at alleviated levels. In trying to do so management also tries to appease the stock market analyst community.
In US, after the 2008 Financial Crisis, their Central Bank had reduced rates in order to stimulate the economy. Federal Reserve started printing a lot of dollars. Thus, the rate of borrowing was at historical lows. Managements of large well run US companies started taking a lot of debt at lower rates and distributed the cash to its shareholders either as dividends or through buyback of the company’s shares from the stock market.
This included giants of US corporate world like Coca-Cola, McDonalds, AT&T, IBM, General Motors, Merck, Fedex, 3M, Exxon among others.
The stock market cheered and the share price increased and the senior management of these companies took home very large payouts.
Companies which had low debt at the beginning of the decade were now heavily indebted. This reduced their financial staying power as irrespective of how the business is doing, interest on debt is a fixed expense and has to be paid. This increases the likelihood of bankruptcy in case of slowdown. A company has reduced ability to withstand slowdowns.
Enter the Covid Pandemic. Suddenly, companies saw their revenue plummet. Profits and cash flow took a hit. Companies with heavy interest burden were on their way to bankruptcy. US’s Central Bank Federal Reserve stepped in to provide liquidity and helped avoid bankruptcy. Problem that was caused by extremely cheap money is being fought with even more cheap and abundant money.
Non-Financial corporate debt recently surpassed $10 trillion and clocking in at 47% of GDP (Gross Domestic Product), has reached highs that the U.S. has never seen before.
The cocktail of low interest rates, easy debt and incentives to take more debt by companies created a Corporate Debt Bubble. And the story is still unfolding…Until then…
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One thought on “Explained: The making of the US Corporate Debt Bubble…”
Since covid was not anticipated by anybody, should we take that the slow growth and low inflation economies like U.S. were not wrong per se in providing cheap money to stimulate demand in the economy.
If no, what could have been done by these economies sufferring from slowdown.
I however agree that debt is dangerous especially in slowdown and should be used cautiously by companies even if it is available at low rate of interest.
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