Debtor's Prison: Corporate America Wrestles With Obligations

Used to be that Peter and Paul were both willing lenders to America's corporations -- and they didn't care so much about calling in their markers.

But the economy isn't what it was a year ago, or especially what it was two years ago. Whereas U.S. companies previously had an easy time borrowing a truckload of money to expand their business (or lay cable that nobody's using at this point), things have changed. Profits are falling and costs are rising, and somebody wants their money back.

What's the easiest way to handle this situation? Take care of the guy who's at your front door with an aluminum bat, and forget about the person who's content at this time to call you on the phone.

In the past several months, companies tapping the debt market (and there have been a lot) have shifted away from short-term instruments like commercial paper to longer-term stuff that doesn't mature quite as quickly or constrict the balance sheet as much.

"It's a combination of the (economic) uncertainty which exists now, compounded by the fact that banks have been tightening their credit standards," said Brendan White, high yield portfolio manager at Fort Washington Investment Advisors.

For corporations, the ratio of debt to net worth is 74.4%, according to the Federal Reserve . In the last year, leverage has risen to its highest levels since 1994. Costs have to be reduced everywhere, and paying off debt is one way to do that. Even the federal government, which has been paying down debt for a while, managed to figure that out.

Burning Holes

Since the debt won't just go away, one way to reduce costs is to alter the mix of your debt, by spreading out more interest payments further into the future instead of paying now when money is scarcer than it has been. For some companies, it's not going to work -- their fortunes are doomed no matter what. But for others, it at least makes some sense, because they can preserve some capital at a time when it's needed.

Even well-capitalized companies are engaging in this sort of maneuver. WorldCom (WCOM Quote), in May, sold $11.9 billion in debt, the largest bond deal by a U.S. issuer. Some of the money could be used for acquisitions, but the intent of the sale was to pay down commercial paper obligations.

Overall, fixed-income borrowing, the sustenance for corporations (contrary to what some in the equity market think), has rebounded this year after a tough 2000. Investment-grade borrowing should surpass last year's total by the third quarter; there has already been more junk debt issued than in all of last year.

Corporate Borrowing Over the Past Five Years (in billions)

Source: Securities Data

In the process, companies are extending the maturity of that paper. The average maturity of existing high-yield debt has increased to 7.76 years in June from 7.57 years in February, according to Lehman Brothers. The same has happened for investment-grade paper, which has seen an increase in maturity, to 10.71 years from 10.46 years. Meanwhile, commercial-paper borrowing is down 3.4% in the second quarter, compared with this time last year, when it was rising at a 25% annual rate, according to Moody's.

What's the reason for this? To protect yourself. The economic environment has turned sour, and that's after several years of euphoria. In giddy times, leverage doesn't feel so bad. Debt levels, when viewed against one's stock price look great, and overall debt doesn't seem onerous when the money is falling out of your pockets. Paying down debt more slowly is preferable. In addition, bonds carry less restrictive provisions than bank debt.

"A lot of this is to term out short-term debt," said Tom Mitchell, assistant vice president and senior investment analyst at Federated Investors. "It provides additional flexibility in the balance sheet, and for companies that need to raise capital, equity is not the currency of choice now." To a lesser extent, this strategy is also a bet on inflation. Your debts don't look so bad if interest rates are rising.

No Homers Allowed

The question, then, is whether this debt reduction or modification will work swiftly enough for corporations to get their balance sheets back in order. For the big names like WorldCom, it's less of an issue. They've got a lot of cash, they operate with a lot of debt, and life goes on. The smaller, lower-rated companies aren't so lucky. Even those that managed to sell debt earlier this year, such as XO Communications (XOXO Quote), still have high leverage.

Bond investors have figured that out. They're not lending money to the telecommunications names anymore. High-quality telecom companies have had their warts exposed, and they're only "high quality" to a junk-bond manager because they had a lot of money, conveniently supplied by said junk manager. Not anymore. So they get nothing and like it.

These various factors -- high debt loads, lack of borrowing from telecom companies, lack of demand -- makes it hard to believe business investment is going to come roaring back this year, or even early next year.

Improving the balance sheet is an important issue for companies. The Federal Reserve's second-quarter data isn't out yet, so it isn't known whether leverage is being reduced a bit, or simply being shifted at this point. Either way, at least Peter, or Paul, is getting reimbursed for something.