The riskiest corporate debtors in the U.S. aren't growing fastenough to pay down their borrowings, increasing the risk for bondinvestors at a time when valuations are already at about recordhighs.

That's the conclusion of Deutsche Bank AG, which estimates thatthe biggest jump in earnings in almost three years may be comingtoo late for speculative-grade borrowers as the amount of debt onbalance sheets climbs back to levels seen in early 2008 before thefinancial crisis. To make matters worse, their ability to makeinterest payments is about where it was in 2007, even as theFederal Reserve has held its benchmark rate close to zero.

“We expect the next restructuring cycle will be dominated bycompanies with good operations but not able to grow into theirbalance sheets or refinance maturing debt,” Kenneth Buckfire,president of New York-based restructuring firm Miller Buckfire& Co., said by email Tuesday.

Investors have piled into junk bonds for their relatively highyields amid the suppressed rates. That has allowed the leastcreditworthy borrowers to raise $1.64 trillion in the bond marketsince the end of 2008, according to data compiled by Bloomberg.

That led to average annual returns of 18.6 percent from 2009through 2013, compared with 17.7 percent for stocks as measured bygains in the Bank of America Merrill Lynch U.S. High Yield Indexand the Standard & Poor's 500 Index.

Debt exceeds earnings before interest, taxes, depreciation andamortization by about four times at speculative-grade companies,near 2008 levels, Deutsche Bank strategists Oleg Melentyev andDaniel Sorid wrote in a Nov. 7 report. Leverage rose even as cashflow grew 12 percent at those companies that had reportedthird-quarter results, according to the New York-basedanalysts.

The Fed has held its benchmark rate between zero and 0.25percent since the end of 2008 to spur economic growth. Yields onjunk-rated debt, which is rated below BBB- by S&P and less thanBaa3 by Moody's Investors Service, have fallen to 6.36 percent,from a peak of more than 22 percent at the end of 2008, accordingto Bank of America index data. Yields touched a record low 5.7percent on June 23.

Debt Coverage

Even with historically low borrowing costs, the ability ofcompanies to make interest payments is about the same as before theglobal financial crisis. Coverage ratios, a measure of earnings tointerest expense, average about 4 times for U.S. high-yieldcompanies, compared with an average of 3.8 times in 2007 and early2008, according to Deutsche Bank. Companies with lower ratios havehigher debt burdens.

While the Fed stopped buying bonds last month under a programknown as quantitative easing, it pledged to keep interest rates lowfor a “considerable time.”

“We're closer to the end of the credit cycle, but we're notquite there,” said Scott Colyer, chief executive officer ofMonument, Colorado-based Advisors Asset Management Inc., whichoversees more than $15 billion. “That usually comes when the Fed istrying to slow down a powerful economy. At this point in time, Idon't see it.”

More investors are anticipating declining credit quality in theriskiest debt over the next six months, while expectations forinvestment-grade bonds haven't changed, according to a Novembersurvey of bond investors by Bank of America Corp.

Most expect the default rate to climb to a range of 2 percent to4 percent in the next year, according to the survey. That's abovethe current 1.7 percent rate tracked by Moody's and the average of4.4 percent since 1993.

“You're deteriorating from a very, very good level right now andyou're entering into a more normal environment,” MichaelContopoulos, head of high-yield and leveraged-loan strategy at Bankof America in New York, said Tuesday in a telephone interview. “Thecompanies that we look at and we think could default next yearprobably should have gone in the past anyway.”

Even as the U.S. economy expanded at a 3.5 percent rate in thethird quarter, capping its strongest six months in more than adecade, signs that global growth is slowing has raised concernamong investors that the riskiest companies might struggle.

The International Monetary Fund reduced its outlook on Oct. 7for global growth in 2015 and Fed Vice Chair Stanley Fischer saidin a speech on Oct. 11 that a slowdown may weigh on the world'slargest economy.

“As the economy slows and we move into the next phase of thecycle, we expect defaults to increase,” Michael Sohr, a moneymanager at AllianceBernstein Holding LP, which oversees more than$30 billion of high-yield debt, said Tuesday in a telephoneinterview.

Bloomberg News

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