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Why corporate America's mountain of debt matters

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The next recession, whenever it arrives, could be deepened by Corporate America's debt-riddled balance sheet.

Encouraged by insanely low interest rates, US businesses have taken on record amounts of debt that funded hiring, acquisitions and generous rewards to shareholders. That borrowing doesn't seem to matter much now because the economy is strong, and companies are minting more than enough money to pay down debt.

But the next recession will expose Corporate America's debt problem, revealing that many businesses binged on too much debt. Those companies will need to rapidly deleverage by slashing jobs, shutting facilities and selling assets. Some will even go out of business.

"The problem with high debt is it limits Corporate America's ability to maintain spending in a growth shock," said Troy Gayeski, co-chief investment officer at SkyBridge Capital.

That may make the next recession worse than it otherwise would be.

"A highly leveraged business sector could amplify any economic downturn as companies are forced to lay off workers and cut back on investments," Federal Reserve Chairman Jerome Powell warned in a speech on Monday night.

Those laid-off workers would then cut their own spending, creating a cascading effect through the rest of the economy.

And investors that enabled the business borrowing will retrench, making it harder for other companies to get financing.

"The pain that investors are going to feel will be quite enormous," said Gayeski.

Debt levels should give everyone 'pause'

By some measures, Corporate America has never borrowed as much as today.

The ratio of nonfinancial corporate debt to GDP is the highest since records began in 1947, according to the Office of Financial Research, a Treasury Department bureau created after the 2008 financial crisis.

Of course, the rise in business debt makes a lot of sense given how cheap it is to borrow. By keeping interest rates near zero for many years, the Fed was encouraging borrowing as a way to stimulate growth.

"To be fair to Corporate America, when the Fed is handing out free money, you probably want to take advantage of it," Gayeski said.

But now the Fed is urging companies to exercise caution.

"Business debt has clearly reached a level that should give businesses and investors reason to pause and reflect," Powell said.

With the stock market near record highs and US GDP growth accelerating during the first quarter to 3.2%, many companies are unlikely to heed that warning just yet.

Record corporate profits, juiced in part by business tax cuts, give Corporate America more than enough firepower to pay down debt.

Just 1.7% of high-yield bonds defaulted during the past year, according to Fitch Ratings.

Kraft macaroni and cheese

Kraft Heinz, which is sitting on nearly $30 billion of long-term debt, has seen its stock price plunge 26% so far this year due to its deteriorating business.

Kraft Heinz, Tesla and GE

However, there are some cracks emerging.

Nearly $10 billion of high yield bonds have already defaulted during the second quarter, according to Fitch. That doubles the total amount of defaults from the first quarter and led Fitch to increase its default forecast for 2019.

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And some major companies have come under fire for their excessive borrowing.

Kraft Heinz, which is sitting on nearly $30 billion of long-term debt, has seen its stock price plunge 26% so far this year due to its deteriorating business. The Warren Buffett-backed food giant is racing to fix its bloated balance sheet by slashing its dividend and selling off brands.

Debt is a key ingredient in the problems facing Tesla as well. Shares of Tesla have plummeted nearly 40% this year as investors fear rising competition and trouble in China will spark a cash crunch at Elon Musk's electric car maker.

General Electric's own debt woes have forced the iconic conglomerate to slash its dividend to a penny, cut jobs and dismantle its empire.

The next subprime? Probably not

SkyBridge Capital is betting against corporate debt, as a hedge against the next recession. The firm's biggest short positions are linked to junk bonds.

"Whatever the cause may be, the acute point of pain will be in corporate credit," said SkyBridge's Gayeski, predicting "explosive upside" for the bets in a recession.

The good news is that, unlike the subprime crisis, this business debt is unlikely to be the cause of the next meltdown.

"The parallels to the mortgage boom that led to the Global Financial Crisis are not fully convincing," Powell said.

He noted that the increases in business borrowing are not "outsized" and haven't been fueled by a "dramatic asset bubble." Powell also pointed out that the financial system today "appears strong enough to handle" business-sector losses. Banks have been forced to bulk up on capital to prevent a repeat of 2008.

And there are signs that growth in business debt has moderated over the past year. That's likely a reflection of rising concern about how much longer the economic expansion can last. Investors have pressured companies to clean up their balance sheets — even in the notoriously undisciplined oil industry.

Still, Powell warned Corporate America against taking on even more leverage.

"Another sharp increase in debt, unless supported by strong fundamentals, could increase vulnerabilities appreciably," he said.

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