Update: Junk-bond defaults will nearly triple 2015-17: report

UPDATE 8/18: "S&P Global Fixed Income Research expects the U.S. corporate trailing-12-month speculative-grade default rate to increase to 5.6% by June 2017, from 4.3% in June 2016 and 2% in June 2015," the credit rating agency said in a report today.

8/12: Debt at U.S. companies is "at record highs," leaving borrowers at least as "vulnerable" to default as in the debt-inflation years just before the last recession, warn analysts Jacob A. Crooks and David C. Tesher, in a report for clients of Standard & Poor's Global Ratings.

"The risks of such debt bingeing are all too familiar," they add. It's "a clear cause for concern" that aggregate leverage (companies' debt compared to their profits) among 2,200 corporate borrowers is "at a recent historic high." 

And then again... "Debt isn't always a bad thing." When money is cheap, some companies load up. If they are profitable, they can pay it off when rates go up or markets stall. -- Companies are now borrowing:

1) To fund mergers and acqusitions.  "Cheap money has enabled acquirers to pursue some of the largest-ever debt-finance deals," such as Anheuser-Busch InBev's $108 billion takeover of rival SABMiller, funded mostly with borrowed money; or Dell Inc.'s $67 billion purchase of EMC Corp.

That's convenient for empire-building CEOs and fee-rich investment bankers. But besides the mass layoffs and customer disruptions mergers bring, "excessive leverage" can be "devastating" to corporate health when the economy stalls, rates jump and lenders stop lending, S&P warns.

2) To avoid paying U.S. corporate income taxes. Big companies "often hold large cash balances outside the U.S. and, instead of repatriating this cash and paying compartively higher U.S. taxes, thy have borrowed as a way to synthetically repatriate the money.... Many of these companies never intended to have such large cash piles overseas," and some would bring it back, if they could get a tax break. 

3) To enrich investors through share buybacks and dividends -- a use of debt that S&P and credit analysts generally disapprove, because it enriches shareholders but doesn't help their bank-lender and bond-investor clients get paid.

4) To invest in their businesses. Isn't that what successful companies are supposed to do?

Actually, "capital spending is below long-term historical levels," S&P notes. But investing borrowed money does help companies boost their return-on-equity ratios, and that makes corporate stocks more attractive to investors.

Big, growing solvent companies "should be able to withstand even a rapid rise in interest rates," S&P notes.

On the other hand, junk-rated companies are issuing more debt, attracting "yield-starved" investors who can't make money from stocks or hedge funds lately.

The analysts also worry that banks, especially since the 2010 federal minimum-capital and regulatory-compliance reforms, are reluctant to lend, and many companies are instead borrowing from insurers, mutual funds and hedge funds -- who are more likely to cut them off in the next recession.

It's not just energy and mining company borrowers, stung by fallen commodity prices, who might be borrowing more than they can afford, the report adds.

Retailers, tech and healthcare companies have all borrowed more in recent years. How well will they endure the next downturn? 

"The debt markets have become a lot more open to all kinds of issuers," says Jody Lurie, vice president and corporate bond analyst at Janney Montgomery Scott in Philadelphia.

Junk bond sales plunged when oil prices collapsed, but have come back since last winter as telecom companies and other borrowers have sold new issues. "There are fewer issuers, but larger deals," she added.

But  "investors are still reaching for yield," Lurie concluded. "We could get too frothy again."

The economy can't do much more than grow slowly, caught as it is between high and rising debt levels, weak European and Chinese demand, the aging U.S. population and its healthcare needs, and low productivity growth, says Brian Kloss, portfolio manager and Head of High-Yield bond investing at Brandywine Global Investment Management in Philadelphia.

Kloss says the real risk to the economy, these days, is political. He sees "a battle between Main Street and Wall Street" -- between commercial banks and small investors, who want to see higher interest rates, and investment banks and trade financiers, who want money to stay cheap.

If the federal government or the Federal Reserve act too forcefully to try and stimulate the economy or boost rates, Kloss says there's a greater risk of recession.

And interest rates are already going up, whether governments want it or not, Kloss added.

The 3-month London Interbank Offered Rate, the benchmark for adjustable-rate business loans and mortgage and credit card loans, has zoomed to 0.8 percent, from 0.3 percent last year -- twice as much as the Federal Reserve's 0.25 percent increase last December.

"Anyone with a floating-rate mortgage or car payment or credit card is tied to Libor," Kloss reminded me. "And that's not even counting derivatives. That's a huge increase. If (Fed) rates go up another 0.25 in December, that could mean a 1 percent (one-year) rise for Libor."

Most U.S. home mortgage loans, at least, are locked in at fixed rates. "But governments are front-end-loaded" with variable-rate debt, and their costs will rise with interest rates, too. 

NEW 8/16: "The financial (and) banking system is tightening," writes David R. Kotok, chair and chief investment officer at Vineland- and Sarasota-based Cumberland Advisors. He says his firm has pulled out of junk bonds, "opaque fund-of-funds type hedge funds," and illiquid timed funds. "If you cannot turn it into cash," Cumberland "won't touch it."

What spooked him? The rules have changed, as they sometimes do, even without the Federal Reserve to boost rates, Kotok writes.

Tougher capital rules have pushed Vanguard and other mutual-fund giants to split their money-market funds into just-about-guaranteed High Quality Liquid Asset funds, and slightly riskier, higher-yielding funds that include commercial paper.

Result: Investors at Vanguard are going for the safest paper, even if it's the lowest-yielding, writes Jeffrey DeMaso, research director at Dan Wiener's Independent Advisor for Vanguard Investors newsletter. "Investors are sucking billions per month out of prime money market funds, which invest mainly in short-term debt issued by companies, and pouring it into funds focused on government debt," DeMaso writes.