In focus

Covid-19's toll on credit fundamentals


With the second quarter earnings season behind us, it is a good time to take stock of the effect the Covid-19 shock has had on corporate credit fundamentals.

Unsurprisingly, earnings are down sharply, although not as much as expected a few months ago. Both in US and Europe, most companies have managed to comfortably exceed the depressed expectations with the highest earnings beat rates in 10 years.

For corporate credit, this means that fundamentals have not deteriorated perhaps as much as was feared at the beginning of the pandemic. In addition, companies have built up significant cash reserves, while debt servicing costs are manageable in most cases even after the recent drop in earnings.  

Nonetheless, the situation is still very fluid and a significant set back in the economic recovery could quickly lead to renewed worries on debt sustainability. Also, lower rated companies are in a more precarious position and have less breathing room to navigate the uncertain waters.

Investment grade fundamentals

US investment grade (IG) gross leverage, the debt to earnings before interest, tax, debt and amortisation (EBITDA) ratio, continued to inch higher in the second quarter, rising to an all-time high of 3.4x. While the increase in the first quarter was driven mostly by a jump in debt as companies drew down emergency credit lines, the increase in the second quarter was also affected by a big drop in EBITDA.

The sectors most exposed to Covid-19 saw the greatest increase in leverage. For example, US IG consumer discretionary sector gross leverage almost doubled, from 2.3x in the end of 2019 to 4.1x. 

Interestingly, net leverage, that is gross leverage adjusted for cash, has increased less. This means that instead of immediately spending the borrowed funds, most companies retained them in cash on the balance sheets. And the relatively fast rebound in the economy has left the cash reserves unused in many cases.

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Debt growth remained relatively brisk in the second quarter. As of the end of August, year-to-date US IG issuance is now close to $1.5 trillion, twice the amount at the same point last year. Granted, some of the proceeds have been used to pay down credit lines, as the outstanding corporate loans have fallen by $300 billion since May.

Looking ahead, leverage is likely to continued rising in the last two quarters of the year. Since EBITDA is measured on a rolling four quarter basis, the effect of the Covid-19 will take some time to fully filter through.

Nonetheless, companies have started to put a greater focus on balance sheet repair, reviewing spending plans and issuing more equity to reduce the share of debt in the capital structure. This should mean that leverage will start to fall in 2021, barring any adverse economic scenarios.

While earnings have seen a similar fall in Europe, companies have been so far more restrained in respect to debt growth. Euro IG debt issuance has risen just 20% in 2020, compared to this time last year. Consequently, the increase in Euro IG leverage has been less pronounced. Furthermore, even though gross leverage is now at an all-time high at 3.5x, net leverage is level with the previous peaks in 2001 and 2009.

Interest coverage is adequate for most higher rated companies

It comes as no surprise that structural decline in interest rates has made debt more affordable, allowing companies to carry higher leverage, all other things equal. But does this arithmetic still hold after the Covid-19 shock?

Because of the contraction in earnings, interest coverage ratios – EBITDA to annual interest payments – have fallen in the last two quarters. Nonetheless, for most investment grade companies, earnings remain sufficient to comfortably cover interest payments

Specifically, US IG interest coverage ratio fell to 7.5x in the second quarter. While this is the lowest since 2010, it is still higher than in the previous cycle bottoms in 2001 and 2009. Going forward, record low bond yields should support interest coverage even when the EBITDA takes some time to recover. In fact, a part of the elevated US IG issuance reflects companies taking advantage of record low yields and refinancing their debt at longer maturities.

Despite falling in the last two quarters, Euro IG interest coverage ratio remains very strong at 9.5x. After moving in lockstep for a long time, US and Euro coverage ratios have diverged somewhat in recent years. This is at least partially because the average cost of debt has fallen more in Euro IG than in US IG, currently standing at 2.7% and 3.7% respectively.

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Companies are holding more cash  

The increase in cash levels, indicated by the widening spread between gross and net leverage, is also visible when comparing cash and debt directly. Investment grade cash to debt ratios have risen sharply in the last two quarters, echoing the dash for cash that occurred after the financial crisis. Furthermore, cash as a percentage of assets is at the highest level ever at around 6% in both in US and Euro IG.    

Looking ahead, companies are likely to continue to hold extra cash as long as the uncertainty over Covid-19 persists. For credit investors, this is no doubt a positive development, as higher cash balances improve flexibility and the ability to service the debt. For equity investors, on the other hand, the high cash levels could mean lower return on assets, all other things equal.

Interestingly, the increase in cash levels bares some similarities to the corporate behaviour in Japan, where corporate cash balances have risen relentless over the last decades, at the time when corporate investments have been lacklustre.   

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High yield fundamentals in a more precarious position

In the high yield (HY) part of the credit market, corporate leverage has followed a similar path. In US HY, leverage  had been relatively stable since 2016 before increasing sharply over the last two quarters. Similarly to IG, net leverage has risen less than gross leverage, implying that companies have retained a large share of the borrowed funds on their balance sheets.

In addition, the issuance in the US HY market has been less buoyant, reflecting lower investor demand for the debt of speculative-grade companies.

In Euro HY, leverage also continued to increase in the second quarter. While leverage in both regions is now at a similar level, when compared to history, Euro HY leverage is significantly less extended. In fact, Euro HY net leverage has only now surpassed the previous peak set in the early 2000s.

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Looking at the interest coverage ratios in HY, the situation is somewhat less rosy compared to IG. The drop in US HY EBITDA over the last two quarters 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 situation in HY 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. Also, the energy sector has a much larger share in the HY market, meaning that the oil price will have much greater impact on HY fundamentals.

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Deterioration in fundamentals not as bad as feared

The hit from Covid-19 on corporate credit fundamentals has been less severe than expected. Corporate leverage is now at record highs across the board, but interest coverage and liquidity ratios have not deteriorated as much. Fundamentals do remain somewhat 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, especially in IG, have retraced most of the widening, there is not much room for mistakes for highly levered companies. In the coming quarters, balance sheet management is likely to become crucial in return to normality and recovery from the Covid-19 shock.