Credit Market Recovery: A year in review
Kay Herr, CFA
At this time last year, our analysts across Global Fixed Income, Currency, and Commodities Research were furiously slashing cash flow estimates, stressing balance sheets, assessing liquidity, and girding for a protracted recovery. When reporting first-quarter earnings last year, the vast majority of companies withdrew their guidance for 2020 earnings, citing an inability to forecast future earnings amid government-mandated lockdowns. For the first time in our careers, we had a global pandemic with pervasive economic impact across all sectors and geographies. A year later, as companies begin to report first quarter 2021 earnings, we thought it would be worthwhile to review credit conditions and how they have changed in the last year.
Before the pandemic, with historically low interest rates and ready access to cheap capital, leverage for U.S.-based investment-grade companies continued to rise from 1.4x in 2011 to 2.8x one year ago. Leverage in U.S.-based high-yield companies had also been increasing, reaching 4.5x last March. Following a multi-year period of de-leveraging before the pandemic, overall leverage in emerging markets was less than in developed markets at the onset of the pandemic.
While leverage levels were elevated in the U.S. investment-grade universe in particular, cash balances were also elevated, creating a marked gap between gross and net leverage (as shown in Figures 1 and 2). The difference, of course, can be explained by growing cash on corporate balance sheets (shown in Figure 2 below as both a percentage of gross debt as well as assets). Significant support by central banks in the U.S. and Europe led to the re-opening of financial markets; companies capitalized by issuing record amounts of debt in 2020, resulting in substantial cash balances. So far in 2021, companies have maintained higher levels of liquidity to withstand prolonged economic weakness.
Figure 1: Gross and Net Leverage & Figure 2: Elevated Cash Levels
Leverage peaked in the second quarter of 2020 across both developed and emerging markets as well as the investment-grade and high-yield universes. While leverage is improving, on the basis of both recovering EBITDA as well as lower debt levels across most sectors, we note that leverage remains elevated in sectors most impacted by the pandemic, such as leisure and retail, where EBITDA has yet to recover (see Figure 3).
Figure 3: Improving Fundamentals
Companies improved their leverage profiles over the last year by reducing operating costs as well as capital expenditures, dividends, and share buybacks. With the worst of this credit crisis behind us, we believe that companies will begin to increasingly refocus on shareholder returns, increasing dividends and buybacks, as well as capital expenditures, in the coming quarters. Mergers and acquisitions, which typically follow increases in share prices, have also been increasing this year.
Figure 4: Dividend Payout Ratio
Starting in 2019, (as seen in Figure 5), the rating agencies accelerated the pace of downgrades due to elevated leverage levels and concerns that the economic recovery was late in the cycle. Downgrades peaked in the second quarter of 2020, coincidentally, when the economy troughed. As shown below, downgrades have fallen dramatically since last year. We expect continued stabilization in ratings commensurate with our forecast for improvements in both EBITDA and leverage. At this time last year, we were focused on potential fallen angels; our focus has shifted to rising stars with the expectation for some upgrades of high-yield credits to investment grade in the next year. Indeed, rising stars have outpaced fallen angels in 2021.
Figure 5: Rating History
Reflecting on the last year, the economy and corporate profits rebounded far more quickly than the market anticipated. Amid signs that the economy and corporate earnings are recovering and downgrades have moderated, our outlook for fundamentals remains positive.