The turn: high yield on the road to deleveraging
Tom Ross, within the Global Corporate Credit Team, looks at whether the trajectory of credit fundamentals supports the strength in high yield bond markets.
- High yield bond prices have recovered sharply in the past year, partly in anticipation of improving corporate prospects.
- Data reporting schedules mean credit metrics will lag actual recovery, but evidence is already mounting of fundamental improvement.
- Selectivity remains paramount and we view sectors along three distinct categories in terms of their capacity to recover.
We are now more than a year on from the sharp falls in asset prices at the start of the COVID-19 crisis. It is fair to say that the recovery in asset markets has been rapid. Central bank support and government stimulus packages have succeeded in tempering the economic damage that would ordinarily have resulted from the closure of whole swathes of the economy.
High yield corporate bond markets have responded positively. Credit spreads (the additional yield that a corporate bond pays over a government bond of equivalent maturity) widened aggressively during the early part of the crisis in 2020, yet by mid-May 2021 global high yield credit spreads had tightened back to almost pre-crisis levels.1 But what about all the extra debt companies have taken on to tide over the loss of revenue during lockdowns? Are markets saying that debt levels do not matter?
Indebtedness may have peaked
A cursory glance at the chart below shows the rapid rise in corporate indebtedness (leverage) in Europe. The gross leverage ratio (Total debt/EBITDA) measures the total debt that a company has relative to its earnings before interest, tax, depreciation and amortisation are deducted. This provides a multiple of debt to earnings. Net leverage (Net debt/EBITDA) is the same ratio, but with the total debt reduced by the amount of cash (or equivalents) that the company holds on its balance sheet. A higher multiple reflects more indebtedness and vice versa. The chart may initially look bleak but there is a lot we can infer from it.
European high yield leverage ratio
Source: Morgan Stanley Research, Bloomberg, company data, quarterly datapoints, December 2003 to December 2020. Gross leverage ratio = total debt/earnings before interest, tax, depreciation and amortisation (EBITDA). Net leverage = net debt (total debt minus cash and cash equivalents)/ EBITDA. Earnings are on a trailing 12-month basis.
First, note the big gap between gross leverage and net leverage. This tells you that, in aggregate, companies within the high yield market have been hoarding precautionary cash. In fact, according to JP Morgan, European high yield issuer cash balances grew to a record level of approximately €190 billion at the end of 2020.2 This is likely a reaction to the stop-start nature of lockdowns, as well as some companies opportunistically raising cash while borrowing rates appear cheap. With vaccine programmes advancing and economies re-opening, we can probably expect some pay down of this debt or the cash to be put to more productive uses.
Second, the net leverage figure fell in both the third and fourth quarter of 2020. This was at a time when many European economies and other parts of the world were operating social distancing restrictions, so the economy was not operating at full capacity. Companies were getting better at reconfiguring supply chains and operating more efficiently, but Morgan Stanley reported that earnings at high yield issuers still dipped 2% quarter-on-quarter in the final quarter of 2020.3 Companies, however, cut their capital expenditures, freeing up cash. Reduced dividend payouts to shareholders were another way to retain cash in the business.
Third, there is a lag of three to six months for aggregate leverage figures to become available. This is because we have to wait until companies have officially reported their earnings and the state of their balance sheets. The final datapoint on the chart, therefore, gives a snapshot of where companies were a few months ago rather than where they are today. Both anecdotally from conversations we are having with issuers and from the stream of data coming through, we know that the economic picture has been improving. While the first quarter of 2021 involved ongoing restrictions, the rollout of vaccine programmes has allowed a gradual re-opening. We have seen from high frequency data (such as retail sales and public transport usage) within countries that are advanced with their vaccine rollouts that confidence is rapidly returning and activity levels are picking up. For example, gross domestic product growth data in the UK showed a strong rebound in March as schools returned, online sales grew and construction picked up.4
Three distinct categories
What is more, debt has not been amassed homogenously. This is worth bearing in mind when looking at aggregate debt levels. Companies within different sectors will have had very different experiences. First, there are those companies totally unaffected or even benefiting from COVID (such as content streaming companies and logistics). Here, earnings have remained robust and debt (if it has grown) has typically been to fund growth rather than to pay for revenue shortfalls. Second, there are those companies in cyclical sectors, such as autos, resources, chemicals and consumer goods, that have been able to bounce back as manufacturing has recovered and consumers have begun to spend more freely on goods. A third category are those areas of services that are still hampered by social distancing restrictions, such as sectors associated with international travel; here there is less clarity on when leverage levels may begin to decline.
Ultimately, we care more about where leverage will be in six to eighteen months’ time as opposed to right now. Of course, this assumes companies have sufficiently resistant balance sheets or access to liquidity to see them through to better times. Most do, which is reflected in a global high yield default rate that is well below peak levels of the last major crisis.5
Clearly, there are threats to corporate credit valuations, from vaccine resistant variants leading to fresh economic dislocation through to worries about inflation, but the experience of the third quarter of 2020 showed that earnings can recover rapidly when economies are allowed to reopen. The loss of revenues and rise in leverage was abrupt, but so too could be the recovery.
1Source: Bloomberg, ICE BofA Global High Yield Bond Index, government option adjusted spread, 17 May 2021.
2Source: JPMorgan, adjusted for issuers that were yet to report, 13 April 2021.
3Source: Morgan Stanley, median figure, 7 May 2021.
4Source: ONS, GDP monthly estimate, UK; March 2021, 12 May 2021.
5Source: Moody’s. The trailing 12-month default rate for global speculative bonds peaked at around 6.8% in December 2020, compared with 13.4% in 2009 following the Global Financial Crisis, 10 May 2021.
Balance sheet: A financial statement that summarises a company's assets, liabilities and shareholders' equity at a particular point in time.
Cyclical sectors: sectors that are highly sensitive to changes in the strength of the economy, such as miners or companies that sell discretionary items, such as autos.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due. The default rate is a measure of defaults over a set period as a proportion of debt originally issued.
High yield bond: A corporate bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon (interest payment) to compensate for the additional risk.
Fundamentals: the basic information that contributes towards the valuation of a security, including financial information, growth prospects and qualitative factors such as management experience.
Yield: The level of income on a security, typically expressed as a percentage rate. For a bond this is calculated as the annual coupon payment divided by the current bond price.