US Fixed Income

Credit market’s brave new world

Global Equities

Credit market’s brave new world

John Lloyd and Andrew Griffiths, Co-Heads of Credit Research, together with Portfolio Manager Seth Meyer examine the improving credit trends as corporate bond markets emerge from the COVID pandemic but caution that much of this is already priced in.

Key Takeaways

  • Corporate failures have been remarkably low considering the extent of economic dislocation but business may yet be tested as support schemes come to an end.
  • Credit ratings appear to be on an improving trend but lenders will want to see evidence that effort is made to reduce borrowing levels built up during the crisis.
  • The default rate may be structurally lower but absolute levels of debt and low yields may limit how much further spreads can tighten.

There were 19,911 corporate bankruptcies in the US in the twelve months to the end of the first quarter of 2021.1 Behind each one of those figures lies a lot of individual and collective misery.

The coronavirus pandemic has been particularly cruel for some. And yet, what if you were to be told that these figures were down on the previous quarter. Or that the total corporate failures for 2020 was lower than the preceding year. Or that this phenomenon was repeated in other countries such as the UK, France and Germany. Is this really the outcome you would expect from a global pandemic and the accompanying economic dislocation?

If we visit the default rate for high yield bonds (also known as sub-investment grade or speculative grade) we can see a distinct pick-up in companies failing to meet their repayments to bondholders in 2020.

Figure 1: Global speculative-grade default rate, trailing 12 months

Source: Moody’s Default Report, 12 May 2021. Moody’s baseline forecast for the year to April 2022. The forecast is an estimate only and is not guaranteed.

Even here, however, there is something interesting at work. The peak in the default rate is noticeably lower than during the 2007-9 Global Financial Crisis.

Partly, this is because banks were better capitalised so lines of credit were not shut down as the economy slowed. Mostly, it reflects measures taken by central banks and governments to facilitate lending. Ultra-low interest rates, together with asset purchases to anchor financing costs at lower rates, appear to have worked. Similarly, government emergency support such as furlough schemes, grants and cheap loans have helped companies through a revenue shortfall as parts of the economy have been shut down.

Forgive but not forget

There has also been a lot of forbearance. Recognising the special circumstances we are in, governments have lowered taxes or stretched the period in which taxes can be paid. Landlords have allowed tenants to temporarily alter rent terms and leasing companies have allowed delayed payments. Creditors have permitted greater flexibility to borrowers by allowing the share of borrowing not earmarked for specific purposes to rise and average tenors to be increased. The understanding is that companies will act to cut borrowing levels when normal economic life resumes.

Yet, the bills will come due. Furlough schemes are set to end, and as other temporary support measures are removed there is the prospect of fresh setbacks. There may yet be a lag in insolvencies.

Downgrades and ratings migration

For the credit rating agencies, companies have been downgraded and some have been demoted from investment grade into sub-investment grade (so-called fallen angels). Yet, we are probably through the worst. Morgan Stanley points out that fallen angels tend to cluster around economic shocks such as recessions as the change in status from investment grade to high yield is typically involuntary.

Figure 2: US industrials: fallen angels tend to be clustered around economic shocks

Source: Morgan Stanley Research, 4 May 2021, US Industrials (non-financial, non-utility). The grey bars indicate periods of recession. The lines show upgrades or downgrades over a rolling 12-month period as a percentage share of a credit rating band. Credit rating agencies assign credit ratings to bond issues. Investment grade rating bands are AAA, AA, A, BBB with AAA being the highest ranking and BBB the lowest. 31 January 1997 to 31 March 2021.

In contrast, downgrades from A to BBB occur regularly outside of recessions. This is because the benefit of retaining an A rating versus a BBB rating in terms of lower funding costs is often not as great as the cost of losing a BBB investment grade rating and paying the higher cost of capital associated with a high yield rating. As such, company managements may be prepared to tolerate movement within investment grade ratings for reasons of corporate direction (such as borrowing to pursue growth) but are less keen on losing investment grade status.

What is remarkable is the speed at which recovery is taking place. The early part of 2021 has already seen the return of ‘rising stars’, these are companies that are recognised by ratings agencies as having sufficiently strong balance sheets and financial prospects to move up from high yield to investment grade. Fiat Chrysler, the autos group, Smurfit, the packaging company, and Verisign, the technology group, are just a few examples of companies that have made the transition up to investment grade status since the start of the year.

Cash: precautionary to predatory

Companies have been reasonably good at cash management during the crisis. This has come principally from two sources. First, many companies took to slashing capital expenditure. This offered a quick means of retaining cash but could potentially tarnish growth prospects in the future as projects that would have delivered returns go unrealised.

Admittedly, some of the capex may have been wasteful but it is probably no accident that governments around the world are keen that companies make up lost ground. Whether it is US President Biden’s proposed Infrastructure Bill, the disbursements of the Next Generation European Union (NGEU) Recovery Fund. or the UK’s super-deduction that allows companies to offset tax against capex, there is an emphasis on productive – and sustainable – capital investment.

Second, companies have raised fresh capital. If we look just at Europe, Bank of America estimates that euro area non-financial companies have raised €949 billion of fresh debt capital between March 2020 and April 2021 with a 55:45 split in favour of bond issuance versus bank loans. High yield companies have been more active than investment grade in terms of net supply of new bonds, with net growth as a percentage of initial size of the market outstripping growth in investment grade markets in euro, US dollar and sterling markets.2

The question now is whether this cash, which last year was being raised for precautionary purposes, becomes a ‘war chest’ for future projects, including potentially bondholder-unfriendly merger and acquisitions, dividend hikes or share buy-backs.

Swift recovery

The vaccine programmes mean that economies in many parts of the world are starting to reopen. Earnings are expected to swiftly recover. Companies had become reasonably good at coping with COVID by reconfiguring supply chains and seeking out new ways to reach customers. With reopening, however, more cyclical sectors such as energy and leisure have seen bond prices rally in response to higher commodity prices and the gradual removal of lockdown restrictions.

Cash flows had already begun to mend by the end of last year and should rise further as operating revenues recover. There will of course be some demand on cash for restocking and working capital as activity ramps up but the prospects for companies to begin the long process of tackling their higher debt burdens will commence. This is not inconsiderable, given that many companies have had to finance a year of reduced revenues.

Figure 3: Cash flow is on the mend

European high yield free cash flows improving

Source: Morgan Stanley Research, Bloomberg, as at 28 May 2021. Company data, Q1 2003 to Q4 2020. yoy = year-on-year change over last 12 months.

The good news is that central bankers are alert to their plight. While it is not in their remit to keep unprofitable businesses afloat, they are determined to keep monetary policy accommodative to allow the recovery to cement itself. In fact, market volatility earlier this year was predicated on fears that central banks were paying too much attention to supporting economic growth and not enough to the risks of rising inflation. For now, we agree with the central banks. The rate of change in economic data is currently distorted but will likely slow both for economic growth and inflation as base effects work their way through the figures.

This all paints a reasonably upbeat picture of rising earnings, an improving trajectory for credit ratings and a low default environment. But is much of this priced in? After all, credit spreads which widened during the crisis have since narrowed back towards their tights.

Intriguingly, Deutsche Bank in its recent annual default study noted that while the default rate has become structurally lower in the last couple of decades, credit spreads have remained at similar average levels (see Figure 4). Investors are being paid the same for taking on much less default risk. Or, to flip it around, investors are being paid more for taking on a given level of default risk.

Figure 4: USD Single B average spreads (bps) and average default rates

Source: Deutsche Bank, ICE Indices, S&P, as at 25 May 2021. Data for 31 January 1988 to 30 April 2021. Basis point is 1/100th of a percent. 100 basis points = 1%.

They point out that companies are benefiting not just from the low interest rate environment helping to keep funding costs low, but also from profits having taken a higher share of gross domestic product (GDP). US corporate profits have averaged around 11.6% of GDP since 2004, compared with 7.7% in the years prior to 2004.3

The post-COVID bargain

Can companies continue to extract a high proportion of GDP? This is a key question and one that is worth keeping an eye on in the coming months and years. Governments are likely to want payback for their emergency assistance. The US and UK are set to raise corporate taxes and there is growing global enthusiasm to establish a common tax on digital sales. Issues of inequality were also raised during the pandemic, which is placing pressure on governments and companies to improve pay for the low-paid. Similarly, environmental, social and governance considerations and consumer and investor pressure mean companies can no longer shirk their responsibilities in these areas.

Perhaps the market is being sensible by recognising that while default rates are structurally lower, this is offset by higher overall levels of debt and a still uncertain outlook. We should also treat spread levels with caution as they are the additional yield on top of the government bond yield of equivalent maturity. With government bond yields at low levels, the tight spreads mean corporate bond yields are also low. Investors think in absolute levels as well as relative levels. Outperformance within credit markets, therefore, is likely to rely more on selecting individual corporates with improving fundamentals rather than the general spread tightening that has characterised much of the past year.

1 Source: Administrative Office of the US Courts, as at 28 May 2021. Table F-2: Business and Non-business Cases Commenced, by Chapter of the Bankruptcy Code. Data for All Chapters during the 12-month period ending 31 March 2021.

2 Source: Bank of America Global Research. ‘Credit Strategy – Europe: Dawn of the European credit upgrade cycle’, 19 May 2021.

3 Source: FRED, US corporate profits before tax as a percentage of US GDP, periods Q1 2004 to Q1 2021, and Q1 1988 to Q4 2003.

Any reference to individual companies is purely for the purpose of illustration and should not be construed as a recommendation to buy or sell or advice in relation to investment, legal or tax matters.