Decades of cheap money has left businesses in America and Europe addicted to debt. Some companies have been borrowing cash just to dole it out to shareholders. But with interest rates now reaching levels not seen in 15 years, those debt-drunk firms are waking up to the threat of a mighty hangover.
On this week’s podcast, hosts Tom Lee-Devlin and Alice Fulwood ask if those firms can kick their debt habit. Goldman Sachs’ chief credit strategist, Lotfi Karoui, explains how companies became hooked in the first place—and what will happen when they start cutting back. And Torsten Slok from Apollo, one of the world’s largest private capital managers, tells them why the cost of borrowing isn’t likely to fall any time soon.
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On May 14th, Envision Healthcare, an American company that provides doctors to hospitals, declared bankruptcy.

Now, that company says it was hurt by a national shortage of clinicians and cited the impact of inflation on its business.

While the company blamed wider challenges in the healthcare sector, a major factor in its collapse was the mountain of debt that had been added to its balance sheet when it was taken over by KKR, a private equity firm, in

Over the past 2 decades companies in America and Europe have been on a debt binge, using cheap credit to fund not just investments but record shareholder payouts.

The corporate bond market really benefited the last couple of years from this low-rate environment, got very comfortable with issuing a lot of debt.

Since 2000, the stock of non-financial corporate debt across America and Europe has grown from $13 trillion to $38 trillion, rising from 68% to 90% of GDP.

Now, with interest rates on the rise and economies slowing, cracks are starting to show.

We saw 7 bankruptcies in corporate America on Monday, which is the greatest number of bankruptcies seen on a Monday in a dozen years.

And it's not only debt drunk firms like Envision paying the price for overindulging.

With the easy money party now over, even the steadiest corporate giants are waking up to a mighty debt hangover.

You're listening to Money Talks from The Economist, our weekly podcast on the markets, the economy and the world of business.

And in today's show, can companies in America and Europe kick their debt addiction?

First, we'll examine why companies like Envision Healthcare have been the first to crumble under their enormous debt piles.

Then we'll hear how rising borrowing costs will ripple through the corporate world.

It should push managements to be more conservative in terms of deploying their debt capital.

And finally, we'll learn why that new world may not look the way many have predicted, and what that means for companies and their investors.

Rates are likely to stay higher for a lot longer than financial markets are expecting at the moment.

Yes, he's on a well-earned holiday in some remote corner of the planet, though he has sent in a stat of the week for later, which is more than I can say for you last week, Alice.

Alice Yes, I unfortunately neglected to do that last week.

My stat of the week for last week was 0, which was the number of hours I wish to work, and I got as close to that as I possibly could.

Sam Well, also very well deserved break for you Alice.

But to kick us off this week, I actually wanted to start with a stat as well, and that is 4%, which is the amount that the combined profits of American and European non-financial companies will shrink by for every percentage point increase on the interest rate they have to pay on their debts.

Yeah, I agree that's a really striking statistic and it's something of a problem, right, because interest rates all over the world have increased very sharply over the last year.

So the Fed has increased rates in the US from roughly 0 a year ago to 5.25 percentage points.

Now, rate increases have only been a little bit less aggressive in Europe and the UK.

And that's why I wanted to talk about debt today.

So many of us are worried, I think, about the impact of rising interest rates on our mortgages.

But for those of us who were lucky enough like yours truly to fix our interest rates before they went through the roof, we haven't really felt the impact of that yet.

And a lot of companies which have been loading up on debt in the past decade or so are actually in a similar situation here.

Yeah so a few weeks ago obviously you and Mike were ribbing me on whether I had done the right thing buying a house when US interest rates are at their highest level in sort of 15 years or so.

But the mortgage market is complicated enough to figure out, but the sort of many ways in which companies can borrow is much, much more complex, depending on their size, owners, and lots of other factors.

So just to get us started for listeners who are not so familiar with this space.

Could you help unpack how the corporate debt market works?

Yeah, so for this episode we'll focus mostly on non-financial companies, just to keep things simple.

So not looking at banks, insurers and the like.

And at a very high level you can think about a sliding scale from the riskiest to the least risky corporate borrowers.

And at the top of the spectrum, you have what are called investment-grade borrowers, and that's credit ratings between BBB and AAA.

And those are typically very large companies and they're seen to have a very low risk of defaulting on their debts.

Typically those investment grade companies rely on issuing bonds, mostly into public markets that pay a fixed rate of interest.

Then as you slide down the credit rating scale, you get to speculative or high-yield or junk borrowers, as they're interchangeably called.

And there, the chances of getting your money back are a bit dicier.

Around half of the debts of those speculative grade companies in America and Europe are based on high yield bonds, which have fixed interest rates.

And around half is based on floating rate loans, which are sometimes sourced from a group or syndicate of issuers and then traded around in what's called the leveraged loan market.

And sometimes they're sourced directly from a private credit firm.

And actually, the further you go down that credit rating spectrum, the more likely you are to have those floating rate loans.

I feel like people often ask me, you know, why on earth would anyone ever bother to borrow at floating rates if you could borrow at fixed ones and guarantee the sort of interest rate you'll be paying on your debt?

But In general, when companies do borrow using floating rate debt, they will get a lower interest rate to begin with.

So maybe they borrow floating for 5 years at, say, 4% or fixed at 6%.

And for those smaller, riskier companies that you were describing, the speculative grade ones, they tend to have taken on a lot of debt and in an interest rate stable world, the savings from using floating rate loans can really add up.

But of course, that comes with more risk and the risk is coming back to bite a lot of those firms now.

And in particular, a big chunk of that risky floating rate debt is held by the portfolio companies of private equity or PE firms that have been particularly enthusiastic users of debt over the past decade or so.

Some of those PE funds have used interest rate hedges, so have some protection against rising interest rates, but certainly not all.

And already we're starting to see some signs of strain here.

So according to S&P, which is a ratings agency, the number of bankruptcies among PE-backed firms in America is already on track to roughly double from last year.

So how bad do you think all of this is going to get then, Tom?

Well I think there is some cause for comfort in the fact that only about a third of the total non-financial corporate debt stock in America and Europe is speculative grade and then only about half of that is on floating rates.

But that doesn't mean there's not a world of pain ahead for all those companies that have pumped themselves up with debt over the past decade or so since the financial crisis.

Now, to better understand the journey that debt markets have been on and where we might be heading next, I spoke to Lotfi Karoui, who is the Chief Credit Strategist at Goldman Sachs.

Lotfi, thank you so much for joining us on Money Talks.

Could you just start by giving us a brief description of what the market for corporate debt was like in the US and Europe in the period after the financial crisis and up to the pandemic and some of the major developments during that period?

Corporate debt markets across the board experienced significant growth post global financial crisis.

So I'll take public debt markets as a proxy.

So that includes essentially debt claims that are syndicated for the most part to institutional investors.

If you look at the dollar market, that actually more than doubled in terms of size from 2010 to 2020.

While in the euro area, the market grew by over 40% over the same time period.

And so a lot of this growth, quite frankly, has been or had been a natural response to ultra low rates.

You know, We had a period of time during which policy rates were at 0, pretty much.

And so borrowers responded to that by essentially deploying more debt on their balance sheets.

The result of that was steady sort of deterioration in credit quality, especially in the investment grade market.

So that's the high quality part of the credit universe.

1 stat that I think captures that steady deterioration is the fact that, for example, the share of BBB rated firms, and so this is the low end of the rating spectrum in the investment grade market, that went from

And so the story essentially of that post global financial crisis period is rapid growth in debt and more leverage deployed on corporate balance sheets.

And the pandemic brought a whole host of uncertainty and upheaval to debt markets.

Within corporate credit markets, I think things sort of played out in 2 acts.

I think the first couple of weeks following the COVID shock saw a significant increase in funding costs, but also a rapid contraction in credit availability.

We saw actually a lot of high quality companies having a hard time refinancing their debt or rolling it over.

And so there was evidence basically that what started as a health crisis and a severe recession was on the verge of morphing into something bigger, akin to essentially a financial crisis.

And then the second act started on March 23rd, 2020.

The Federal Reserve announced the corporate credit facilities, and de facto that provided the market with a lender of last resort for non-financial corporations, as well as a liquidity provider of last resort for investors.

In the end, the Fed actually didn't buy a lot of bonds.

It didn't really deploy its balance sheet into corporate credit markets in a meaningful way.

But the announcement effect was extremely powerful and that allowed companies across the board, whether it's an investment grade or in the high yield market, to rebuild and strengthen their liquidity positions in a very significant way.

To give you an example, in 2020, we saw new issue volumes in the investment grade market here in the US reaching a record high level of almost $2 trillion.

That was up 60% relative to the prior year.

But that surge in new issue volumes allowed companies to essentially build a very solid line of defense, replenish their liquidity positions, and be ready, essentially, in case the economy were to experience another unexpected shock.

But now we're in this environment where interest rates have surged significantly.

There's a lot of companies out there that maybe have some liquidity buffers as you say but also have just a huge amount of debt that they've accumulated over the past decade or so.

But we're yet to see any kind of meaningful uptick in defaults or even downgrades.

We haven't seen yet a meaningful acceleration in defaults.

And there's a number of reasons for that.

1, it typically does take a full-blown recession for defaults to materially accelerate, and growth has decelerated, but we're not in recession today.

And if anything, I would say the news flow over the last couple of months has been generally quite positive over the prospects of a soft landing, at least in the US.

The second reason is that prior to the start of this hiking cycle, companies were in a position of strength fundamentally.

To the point you made earlier about liquidity positions, companies started this cycle with materially higher levels of liquidity positions than they normally do.

And then 3, the bulk of the liabilities are actually in fixed rate form.

And so even though the level of policy rates has increased quite dramatically, that only spills over to the marginal cost of debt, i.e.

The cost of every additional dollar that you borrow.

But for a lot of companies, that actually doesn't change things that much in terms of the current stock of outstanding debt.

And so the punchline there is that it will probably take a little bit of time for the transition towards a higher for longer cost of capital or cost of funding environment to play out.

Now, there are parts of the credit ecosystem that are feeling the pressure, but in aggregate I would still characterize the current default environment as benign by historical norms.

And looking longer term, what do you think the corporate debt market will look like in the decade ahead compared to the experience of the past few years?

I think if you assume that yields globally will settle at an equilibrium level that is higher than what we had post-global financial crisis.

And there's certainly a lot of reasons to believe that that will be the case.

Then I think that changes the economics of re-leveraging for a lot of companies.

I think what you'll see is companies sort of behaving a little bit more conservatively as far as their capital management plans go.

And so in many ways, the next decade could shape up as sort of almost the mirror image of that period from the end of the global financial crisis all the way until COVID.

And so there are certain things that will feel a lot more expensive to pursue.

So 1 example, the economics of a leveraged M&A transaction where you fund that transaction aggressively in the corporate bond market, that will be a little bit more expensive to execute.

Same thing for the economics of a debt-funded buyback program, where you could borrow very cheaply in the corporate bond market and then redeploy the proceeds into the equity market by buying back your own stocks.

The cost of doing that will be more expensive.

And so that should reduce incentives to re-leverage balance sheets and it should push managements to be more conservative in terms of deploying their debt capital.

Now Alice, 1 line from my conversation with Lotfi really struck me, and that was this idea that the decade ahead could be the mirror image of the decade past when it comes to corporate debt.

If you boil it down, Western firms have been spending more cash on investments and shareholder payouts than they've been generating from their operations for years now.

And they've been plugging that gap by taking out more debt.

Now, if they're going to start to reduce their debt burdens in response to higher rates, they're going to have to do the opposite.

And the big question then is what do they cut?

Either They'll invest less, which will be a big setback to things like decarbonisation and artificial intelligence, or they'll pay their shareholders less, which is bad news for them.

What's your read on the discussion so far?

Yeah, I also am sort of interested in this mirror image idea, you know, what he was describing this potential decade of deleveraging, the hangover from this corporate debt boom.

Well, between 2008 and 2019, we lived through that already for households.

Their debt fell in America from a peak of 100% of GDP in 2008 to just 75% in

And deleveraging is not particularly fun for an economy to go through.

It's much more fun to rack up the credit card debt than it is to pay it off.

And so that period was a relatively sluggish time for growth.

AmeriCorps only grew at around 2% per year for the decade after 2010, compared with 3 or 4% for the decade leading up to 2007.

And on the household side, when you have households you're leveraging, that tends to hit consumption, so they spend less.

But as you suggest, for corporates, it's much more likely to hit the investment side of the economy, which that has some much thornier, longer term implications for growth.

Well, another force that is sure to hit economic growth in the years ahead, albeit over a much longer time frame, is declining birth rates in many of the world's biggest economies.

This week's edition of The Economist features a big take on what an aging and in an increasing number of cases shrinking population means not just for the sustainability of government finances, but also the potential for innovation.

And that's based on some fascinating reporting from our very own Mike Bird in absentia.

And I'm very much looking forward to reading that.

What are you looking forward to reading in this week's edition?

Yeah, in addition to Mike's excellent piece, I have been gripped by the rise and rise and rise of NVIDIA, the chip maker.

Its market capitalization surpassed a trillion dollars a few days ago off the back of a generative AI enthusiasm-based rally.

And 1 of my colleagues, Guy Scripman, has written that there's something akin to the gold rush going on here.

So just as with the original gold rush in America, those raking it in are not necessarily those doing the AI or panning for gold so much as it is those selling the shovels to people that want to do that.

So in this week's issue, we have both a deep dive on NVIDIA and a leader on what its ascent means.

Listeners can read both of those pieces and more for absolutely nothing by going to economist.com forward slash podcast offer for a free 30 day digital subscription.

That is if you're not a subscriber already.

And after the break, we'll hear more about the risks and opportunities that rising interest rates and a slowing Economy present for Private Capital.

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Before the break, we heard that higher interest rates will force companies to cut back on their borrowing.

But how much longer are rates expected to remain at this level?

And what impact will that have on the economy and on investors?

To find out, I spoke to Torsten Slock, Chief Economist at Apollo, which is 1 of the world's largest managers of private equity and private credit.

Torsten, thank you so much for joining us on Money Talks today.

So it feels like we've been anticipating a recession for some time now, but it still hasn't arrived.

Could you start by just giving us your quick take on what the coming months have in store for the US and European economies?

Do you think a recession is likely in the year ahead?

I do think a recession is likely because the important backdrop for this conversation is that inflation in the US economy is still too high.

And the problem with that is that when inflation, taking again the US as an example, is at around 5% and the Fed has an inflation target of 2%, the Fed will then conclude, well, if inflation is 5 and it has to be 2, the Fed has been mandated by Congress that inflation should be 2 percent.

The Fed will say, well, but then we need to keep on stepping on the brakes.

We need to slow down consumer spending, capex spending, hiring with the ultimate goal of getting inflation to come down.

So the short answer to your question, Tom, here is that the Fed is simply not done.

So therefore, interest rates at least need to stay at these levels, maybe even go up a bit more.

And therefore, we do need to see a recession to get to the goal of getting inflation back to the central bank's 2% target.

And what will that mean for corporate earnings?

Yeah, that's a really important question, Tom, because the very significant feature of this current business cycle is that we both have a slowing economy in real terms, but we also have inflation.

So in nominal terms, the economy is actually doing fine.

So that means that from, in particular, an earnings perspective, which are measured always in nominal terms, the S&P 500 has still seen this earnings season that we just came out of, reasonably solid earnings in nominal terms, whereas in real terms, the economy has been slowing down.

It's an interesting point given debts are of course in nominal terms and companies repay those debts from their nominal operating profits.

Presumably though, as both growth and inflation continue to slow, eventually we'll see nominal earnings start to deteriorate too.

If inflation today is 5 and has to get down to 2, we should also expect to see normal earnings growth for corporates slowly move lower over the coming quarters.

And central banks have yet to stop raising rates and presumably are a long way off thinking about rate reductions.

How long do you anticipate that rates will remain elevated for?

All central bank governors and members of the governing council at the ECB, they are saying we will not be cutting rates later this year.

We will probably begin to see rate cuts sometime by the middle of next year.

But the important backdrop for this, and this is very important for financial markets, is that inflation is just too high.

And thinking over the longer term horizon, when rates eventually do start to come down, do you think we will ever go back to the kind of ultra low rates that we had before the pandemic, or is that sort of more of an abnormality?

I do think that we will eventually see interest rates end up at a higher level than where we were before the pandemic.

There's a number of structural reasons to expect inflation to be permanently higher.

First of all, we have de-globalization, meaning more home shoring, on-shoring, French shoring, which essentially has the implication that the cost of production globally are going to go up for countries that decide to take production back closer to their home.

And that should on its own mean higher inflation.

A second force that also argues for higher inflation is that the energy transition is also associated with quite significant investments in energy towards renewable, towards green energy.

And that process is likely to also be associated with higher inflation.

And third and finally, immigration, which has been a very important factor for holding wages down and holding inflation down globally.

If there are now some reversing winds in terms of immigration being lower globally, That also raises the probability that we might see some more upward pressure globally, including in the US on wage inflation and ultimately, therefore, also on consumer price inflation.

So for those reasons, everything combined brings me to the conclusion that we're probably going to see the Fed funds rate not go back to 0 and interest rates not go back to 0, but probably go back to a range closer to 2 to 3%.

That's of course lower than where we are today, but it's still not bringing us back to where we were before.

The private equity model of company ownership has relied quite heavily on cheap debt over the past few years.

To what extent does this environment of higher interest rates and sluggish growth pose a risk to private equity?

Generally I think that what's going on in private markets is actually quite similar to what's going on in public markets.

So what have been the features of public markets for the last 12 months?

Higher interest rates because of higher inflation.

And now we add on to that regional banking crisis in the US.

So with that backdrop, the cost of capital everywhere has gone up for everyone.

So now, of course, the situation is hurting those that when you rely on financing, in particular, don't have the ability to do complex financing, those who don't have different sources of access to different pools of capital to do financing.

So I do think that higher cost of capital from a Fed perspective and ECB and Bank of England perspective is, quote unquote, working in the way that it's intended, namely to try to slow down economic growth.

But it just happens to be that the areas that are most vulnerable to higher interest rates, including in the private markets, are those that are more vulnerable because they have higher leverage.

And growth and tech are the areas that have taken the biggest hit and in the private markets likely also have taken the and will take the biggest hit simply because if you think about it the Feds idea with raising interest rates is to slow down growth.

And to what extent do you think this environment creates opportunities for firms like Apollo that operate across both private equity and private capital to put fresh money to work?

So when you think about the current situation, where you have 2 regular sources of financing for corporates that is essentially shut down, first of all, primary high yield markets essentially shut down, regional banks are to a large degree also shut down.

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Money Talks: The great debt hangover