Magazine article Modern Trader

What's Fueling Corporate Debt Fire?

Magazine article Modern Trader

What's Fueling Corporate Debt Fire?

Article excerpt

What's fueling corporate debt fire? Corporate leverage in the United States has increased greatly in the 1980s due to high real interest rates, according to Robert E. Litan, senior fellow at The Brookings Institute in Washington, D.C.

At a National Association of Business Economists meeting in San Francisco in September, Litan said five theories have sought to explain this "explosion" of corporate debt:

* The federal government income tax code's bias toward debt.

"Although this bias is undesirable, it has been presented for many decades and, thus, cannot be a principal factor explaining the upsurge of debt in the 1980s," Litan says.

* "Bull market arbitrage," as Litan calls it, or the leveraged buyout (LBO) activity driven by arbitrage opportunities for firms with leveraged positions in a strong bull market.

"LBO activity, however, has accounted for only 14% of the increase in corporate debt in the last decade. In addition, there is no correlation in industry leverage and the extent of LBO activity," Litan contends.

* The rise of junk bonds.

"By virtually creating a junk bond market, Mike Milken and Drexel Burnham Lambert lowered costs of debt finance," Litan says.

He maintains this development has played a role but doesn't explain inter-industry variations in debt.

* The "free cash flow theory." This explains inter-industry and inter-firm differences in debt and the fact that firms and industries with imbalances between investment opportunities and cash flow are targets of LBOs, takeovers and debt restructurings. …

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