A high ratio of corporate debt to GDP is tolerable as long as a material contraction of core pretax profits is avoided, according to a new report from Moody's Analytics. According to the 26-page analysis, history shows that the ratio of corporate debt to core pretax profits performs better at explaining high-yield defaults than does the ratio of corporate debt to GDP.

"In terms of moving yearlong ratios, the default rate shows a correlation of 0.83 with the ratio of corporate debt to core profits and a much weaker correlation of 0.41 with the ratio of corporate debt to GDP," the analysts write. "Even if the default rate is correlated with the lagged versions of both ratios, corporate debt as a percent of core profits still outperforms corporate debt as a percent of GDP. All of this makes a great deal of sense. Intuitively, the ability of businesses to service debt should be more closely linked to corporate earnings than to GDP."

Defaults Are Very Sensitive to the Profits Cycle

The profits cycle does not always coincide with the business cycle, the analysts conclude. Though each of the last five recessions was associated with a substantial contraction by core profits, there have been two noteworthy contractions by core profits since 1979 that did not overlap recessions.

The two profits’ recessions that were not linked to economic downturns occurred in 1986 and 2015-2016. For both episodes, the high-yield default rate jumped up from its preceding low by 4.4 percentage points, on average, and eventually peaked at 6.4%, on average, where the latter was well above the default rate’s 3.7% median of 1984-2018.

By comparison, March 2019’s U.S. high-yield default rate of 2.4% was 1.8 percentage points under its year earlier mark. Default researchers at Moody’s Investors Service expect the default rate to dip to 1.9% during 2020’s first quarter, which would be less than its 2.6% average of 2019’s first quarter.

Risks Mount When Corporate Debt Outruns Core Profits

The outlook for corporate credit quality often improves when pretax profits from current production grow more rapidly than corporate debt outstanding, according to the report.

"Basically, when profits outrun corporate debt, the returns from financial capital are ample enough to meet the cost of servicing outstanding debt," Moody's notes.

The risks implicit to today’s higher ratio of corporate debt to core profits compared with 2006-2007 have been mitigated by today’s much lower borrowing costs. For example, recent readings had the three-month Libor at 2.59%, the long-term Baa industrial company bond yield at 4.82%, and the composite speculative-grade bond yield at 6.26%. Each of these recent readings was far under the respective 2006-2007 averages of 5.25% for the three-month Libor, 6.63% for the long-term Baa industrial yield, and 8.23% for the speculative-grade bond yield.

Moody's says that today’s relatively low interest rates are of critical importance to financial stability.

"A still atypically high ratio of corporate debt to core profits warns of the considerable danger implicit to a fundamentally unwarranted climb by benchmark interest rates," analysts write.

Click here to download the report in its entirety.