The Great Leverage 2.0? A Tale of Different Indicators of Corporate Leverage

Abstract: Many policymakers have expressed concerns about the rise in nonfinancial corporate leverage and the risks this poses to financial stability, since (1) high leverage raises the odds of firms becoming a source of adverse shocks, and (2) high leverage amplifies the role of firms in propagating other adverse shocks. This policy brief examines alternative indicators of leverage, focusing especially on the somewhat disparate signals they send regarding the current state of indebtedness of nonfinancial corporate businesses. Even though the aggregate nonfinancial corporate debt-to-income ratio is at a historical high, these firms’ ability to service the debt, as measured by the interest coverage ratio, looks healthy. A simple model shows that this pattern can be consistent with firms’ optimal choice of leverage in response to an exogenous decline in interest rates. On the other hand, the model also reveals that the fall in the interest coverage ratio due to a given yield increase is magnified when interest rates are at low levels. The implication is that the elevated nonfinancial corporate debt-to-income ratio that has been present in recent years raises the downside risk of firms becoming unable to service their debt following any adverse shock, such as a decline in income or an increase in risk premia.

Keywords: financial stability; low interest rate; monetary policy; interest coverage; business leverage;

JEL Classification: C60; E43; E58; G32;

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Bibliographic Information

Provider: Federal Reserve Bank of Boston

Part of Series: Current Policy Perspectives

Publication Date: 2020-04-02