A tug of war in credit: fundamentals vs valuations
A tug of war in credit: fundamentals vs valuations
The story of recovery from the pandemic so far has seen many twists and turns. Fortunately, there have been relatively few surprises from corporate fundamentals. After the initial hit from Covid-19, corporate fundamentals have been on the mend since the middle of last year.
The recovery in fundamentals has been supported by three key factors: the rebound in earnings, the slowdown in debt issuance and the fall in the cost of debt. While the damage caused by the pandemic could take a while to fully heal, especially for companies that have been at the centre of the storm, the direction of travel is quite clear.
At the same time, credit spreads have fallen faster than anyone had expected a year ago. In fact, the spreads of most credit indices are now close to all-time lows. Because of that, investors are wondering if they are compensated enough for the risk they take.
Below we look at the developments in fundamentals and to what extent the improving outlook could justify extended valuations.
Companies have started to deleverage
The latest data show that US investment grade (IG) gross leverage, the debt to earnings before interest, tax, debt and amortisation (EBITDA) ratio, ticked lower in Q4, continuing to fall from the record high.
Furthermore, net leverage, that is debt adjusted for cash on balance sheets, has fallen even faster and is now lower than before the pandemic at 2.5x. This means that the gap between gross and net leverage is at a record wide, owing to the significant cash held on companies’ balance sheets.
Looking ahead, delevering should continue in the coming quarters. First, EBITDA, measured here on the rolling four quarter basis, will rebound significantly in Q1, as very negative Q1 2020 drops out. In addition to this base effect, analysts expect US earnings to continue to recover with the economy picking up speed in 2021.
On the other side of the ledger, debt growth remained perhaps faster than expected in 2020, especially for non-cyclical companies. But this has at least partially been a result of companies taking advantage of record low yields and prefunding debt maturities, so issuance should be much lower in 2021.
Across the Atlantic, euro investment grade leverage has turned the corner as well, although the reversal has been somewhat less impressive so far. This is perhaps not surprising, with hiccups in the vaccine rollout forcing countries to reinstate lockdowns. Nonetheless, the worst should be behind in Europe as well, meaning that deleveraging should pick up speed.
Interest coverage is improving
Similarly to leverage, the US investment grade interest coverage ratio – EBITDA to annual interest payments – has started to move higher, standing at 7.6x in Q4. While this is still significantly lower than pre-pandemic, it is higher than in the previous cycle lows in 2001 and 2009. Quite a feat, given much higher debt loads this time.
The resilience of interest coverage again illustrates how the lower cost of debt has cancelled out higher volumes of debt, even when factoring in the record debt issuance in 2020. Similarly to leverage, the recovery in earnings should be a tailwind for interest coverage in 2021.
The euro investment grade interest coverage ratio continued to rebound in the fourth quarter, standing at 9.8x, significantly higher than in 2009. In that sense, the higher interest coverage has at least partly made up for the less rosy earnings outlook.
In the last few months, government bond yields have risen faster than most people had expected. As a result, the yields of corporate bonds have inched higher as well. The question then is, what do higher yields mean for corporate fundamentals?
In the near term, not a whole lot. Because companies issued a record amount of debt in 2020, and have high levels of cash, most companies will not need to raise much new debt this year, so issuance should be low.
Furthermore, even with the latest increase in yields, the yields of US and euro investment grade are still extremely low, standing at 2.3% and 0.3% respectively. So issuing bonds now could still lead to a lower weighted average cost of debt, if the new bonds replace bonds issued at higher yields.
That said, a more sustained rise in yields would eventually put pressure on companies with higher leverage, forcing them to take more drastic measures to cut debt.
As the gap between gross and net leverage shows, companies continue to carry elevated cash balances. In fact, the US IG cash to debt ratio increased further in Q4, now standing at 18x. This indicates that companies have been cautious, largely keeping in place the buffers built in the Covid-19 crisis.
This cautious behaviour is also corroborated by the payout ratios. In both US and euro IG, the total payout ratios, defined as dividend payments and stock buybacks divided by the net income, have fallen to levels only seen in the aftermath of the global financial crisis.
Nonetheless, as the economy recovers over the coming quarters, it is likely that cash levels will fall. For investors, it is important to keep a close eye on any significant developments, especially regarding mergers and acquisitions (M&A) activity. So far, new M&A financing has mostly been financed by equity.
Similarly to IG, the leverage in the high yield (HY) part of the market has started to fall. In fact, the damage caused by the pandemic has almost fully reversed in US HY, at least when looking at the net debt to EBITDA ratio. As some of the lower rated companies are under pressure to cut leverage to avoid financial distress, this is perhaps not a surprising development.
The US HY interest coverage ratio rebounded in the fourth quarter from an all time low of 3x, while euro HY interest coverage increased slightly as well. Despite this improvement, interest coverage is much weaker in HY than IG, both 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. Granted, HY companies have been able to raise a significant amount of liquidity, allowing them some breathing space in the near term.
Ratings upgrades could keep spreads stable
Investors face a conundrum in the credit market: while fundamentals are improving, markets seem to have already priced in a lot of that improvement. It seems unlikely that spreads can fall much more from here. For example, the US IG index option adjusted spread (OAS) stands at 102bps, as of 12 March. The post-financial crisis low is 91bps.
Nonetheless, the silver lining could be that improving fundamentals are likely to pave the way to ratings upgrades in the coming quarters. As the path out of the pandemic becomes clearer, ratings agencies could upgrade some of the companies that were downgraded at the height of the crisis. In fact, in US HY, the volume of rating upgrades exceeded the volume of rating downgrades in January for the first time in a year.
Historically, the periods of net ratings upgrades have been associated with at least stable spreads, for example in 2003-2005, 2013-2015 and 2017-2019. This should give investors some confidence for the rest of 2021, despite the tight spreads.
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