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Lenders Need to Keep Eye on Risk Even as Strong Financial Health Makes Corporate Borrowing Attractive

2:51 PM, May 9, 2018 — Strong financial health has helped drive down corporate defaults, making investors more willing to lend at attractive rates, but trends need to be continually watched for rising risks, Washington Crossing Advisors said Wednesday.

Low corporate bond yields relative to Treasury bonds indicate investor willingness to led to companies amid rising commodity prices, strong cash flow and tax cuts. Borrowers are using the funds to refinance at more attractive rates, the firm said. Some companies are locking in lower-cost debt as interest is expected to rise.

With the economy booming, borrowers aren’t at risk of defaulting on loans, but investors need to remain vigilant in the event that investment risks increase, said, WCA, which is a wholly owned subsidiary and affiliated investment adviser of Stifel Financial.

“The increase in indebtedness of US non-financial companies is manageable in the current environment,” the firm said in a note to clients. “Steady growth, strong cash flow and investor confidence supports today’s low default rates. Still, it is important to keep an eye on how these trends evolve and recognize potential for increased risk, especially among weaker credits, should conditions change.

Moody’s Investment Research data shows defaults by corporate borrowers are now below average with only about 1.4% of borrowers defaulting. The average since the early 1980s is 1.5%, and the high-water mark was in 2009 at 5%, WCA said. The increase in corporate indebtedness has correspondingly risen to a record high of GDP, the firm said.

While borrowing to invest in profitable projects or refinance existing debt makes sense, other motives could be problematic, the firm said.

“At this point in the cycle, companies facing intense pressure to boost otherwise weak organic growth may turn to buybacks and acquisitions,” WCA said. “Strong levels of these activities, which can convey benefits in some environments, could prove damaging if done for the wrong reasons. By leveraging a balance sheet to achieve near-term growth targets, a business increases risk and decreases flexibility, especially if interest costs rise or business conditions worsen in the future. While not a problem at this point, we have seen many times before how debt growth can lead to trouble for the economy.”

If the economy takes a turn for the worse, default rates on lower-quality, non-investment grade issues will double or triple versus those of investment-grade debt. Increasing exposure to higher-quality investment grade and Treasury bonds is one way to decrease credit risk in the even the economy suffers a downturn, WCA said. The firm doesn’t expect such an outcome, but it reduced its natural exposure to high-yield corporate bonds last year and raised its US Treasury exposure from neutral to underweight.

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