Are companies starting to shake off the effects of Covid-19?

Even as large parts of the world are still grappling with Covid-19 and eagerly awaiting the rollout of vaccines, the news from the corporate sector is starting to improve.

The third quarter earnings reports indicate that in most cases, companies have been able to halt the deterioration in corporate fundamentals and have begun mending the damage caused by the pandemic.

Expected economic recovery in 2021 should be a tailwind for corporate earnings, while the measures taken to reduce costs and cut debt should aid in the deleveraging process.

Nonetheless, the situation is still very fluid and a significant set back in recovery could quickly lead to renewed worries about debt sustainability. Given that credit spreads have more or less retraced the widening seen earlier this year, there is not much margin of error for either companies or investors.

In addition, lower rated and smaller companies are in a more precarious position and have less breathing room to navigate the uncertain waters.

Investment grade leverage has peaked

US investment grade (IG) net leverage, the net debt to earnings before interest, tax, debt and amortisation (EBITDA) ratio, ticked slight lower in the third quarter from a record high. It now stands just above 2.5x.

Stabilisation in leverage was driven by three factors. First, the slowdown in debt growth. Second, the rebound in EBTIDA seen after lockdowns eased in the third quarter. And finally, some of the most highly levered companies being downgraded to high yield or taken out of the index through M&A.

While earnings have fallen by a similar amount in Europe, companies have been more restrained in respect to debt growth. Consequently, the increase in Euro IG leverage has been less pronounced, with the net debt to EBTIDA ratio peaking at a slightly lower level, which, granted, is still at an all-time high.

Interest coverage is higher than in the previous cycle bottoms

Similarly to leverage, the US IG interest coverage ratio – EBITDA to annual interest payments – stabilised in the third quarter at 7.6x. While this is the lowest since 2010, it is still higher than in the previous cycle bottoms in 2001 and 2009. This is quite remarkable given significantly higher debt loads.

Of course, it can be explained by the lower cost of debt, a structural trend that has only accelerated in 2020. For example, the US IG index yield has fallen this year from 2.9% to 1.9%, a record low. In fact, companies haven taken advantage of record low yields by refinancing their debt at longer maturities. This can partially explain the record high US IG issuance in 2020.  

Although the Euro IG interest coverage ratio continued to fall in the third quarter, it remains very healthy at 9.2x, much higher than in 2009. In fact, the term “cost of debt” is becoming somewhat of a misnomer in Europe. The Euro IG index yield is a paltry 0.3%, while 42% of bonds are now trading at negative yields.

Cash balances remain high but likely to fall

IG companies continued to carry high cash balances in the third quarter, although the “dash for cash” has clearly abated, with the cash to debt ratio has peaking at around 16x in both US and Euro IG. Because of reduced uncertainty and better growth expectations in 2021, companies are likely to start reducing elevated cash balances by paying off some of their emergency borrowing.

Successful deleveraging is crucial for balance sheet repair

While the hit from Covid-19 might not be as severe as expected in spring, companies still need to repair the damage caused by the pandemic on the balance sheets. The early indication is that most are taking this task seriously.  

Earnings pay-out ratios have already fallen close to 2009 levels and many companies are reviewing spending plans in effort to reduce costs. Coupled with a likely rebound in earnings, leverage should start to fall in 2021, barring any adverse economic scenarios and hiccups in the rollout of vaccines.

Given the record high share of debt on balance sheets, conservative capital management is crucial in supplementing a brighter earnings outlook. This is especially the case for Covid-19 exposed companies that have a greater urgency to act in order to avoid downgrades or defaults.

The high leverage in the IG market, even before Covid-19, can be partially traced to M&A deals that were financed with significant debt issuance. Currently, the pipeline of M&A deals with IG issuance implications is very low and some high-levered companies have recently issued new equity. However, with the yields at record low, debt-financed deal making could return sooner than credit investors would like.

Furthermore, while equity issuance is likely to increase to assist the deleveraging, it is unlikely that debt levels will fall substantially, because the cost of debt remains below the cost of equity, especially in Europe.

High yield in a more precarious position

Similarly to IG, the leverage in the high yield (HY) part of the market has likely peaked. However, looking at interest coverage ratios in HY, the situation is somewhat less rosy.

The sharp drop in US HY EBITDA in the first two quarters of 2020 means that US HY interest coverage ratio is now at an all-time low, standing just above 3x. Euro HY interest coverage has fallen as well, although it is still slightly higher in absolute terms and compared to history. 

The more precarious position of HY companies was already apparent before Covid-19. It is a part of the bigger trend where smaller companies have not benefitted as much from low interest rates as large multinational corporations. Furthermore, larger companies have perhaps disproportionally benefited from government stimulus in 2020.

Granted, HY companies have been able to raise significant amount of liquidity, allowing them some breathing space. Still, the debt sustainability question could re-emerge sooner rather than later, especially as the government support is starting to be phased out in 2020.

Not as bad as expected?

The hit from Covid-19 on corporate credit fundamentals has been significant although less severe than expected. Corporate leverage is at record highs across the board, but interest coverage and liquidity ratios have not deteriorated as much. Fundamentals remain weaker in the HY part of the market.

Investors can certainly find some comfort in the fact that situation is not as bad as feared in the beginning of the pandemic. However, given that credit spreads have already fallen so much, there is not much room for error for highly levered companies. In the coming quarters, balance sheet management is crucial in return to normality and recovery from the Covid-19 shock.