Corporate leverage is set to gain more importance aided by Federal Reserve tapering, mutual fund flows, and stretched credit ratings, according to a report from Citi Research.

Jason Shoup and his team at Citi say corporate leverage is in the crosshairs and ultimately it’s going to impact valuations.

Top American corporates’ leverage back to recession levels

Citi analysts point out in just five years, the most credit-worthy American corporates’ leverage have reached the level last seen at the depth of the Great Financial Recession.

Jason Shoup and team point out that in 2009, investment-grade leverage climbed by roughly 0.5 turns to 2.3 times, largely due to a broad-based decline in revenue /EBITDA. However, the analysts feel the steady increase in corporate non-financial leverage that’s occurred during the past three years has been intentional. This is evidenced from the following graph:

Leverage of non-financials

Taking advantage of ultra-low rates, corporates have not only refinanced upcoming debts due for redemption, but returned capital to shareholders through dividends and share buybacks. Hence, Citi analysts view this as compelling evidence that 2013 may witness an inflection point for the debt markets when it comes to corporate leverage.

Underweight on credits likely to relever

Citi analysts emphasize one of the most profitable strategies for 2013 has been to identify credits that are likely to relever in a material way and underweight those credits well in advance and subsequently buying the new debt in the primary market.

The analysts cite the recent Verizon deal as an example where bonds of maturity over 5 years widened on average of 64 bp before announcement of the deal to acquire the remaining 45 percent stake of Verizon Wireless the company didn’t already own.

Active participation by bondholders

Citi analysts note during the past three years, bond holders have been actively participating in the releveraging exercise of corporate America, though their attitude has recently started showing some change.  With central bank liquidity injections having resulted in records inflows into bond funds, demand for new supply has grown considerably.

Citi analysts point out the importance of leverage would grow in the future aided by Fed tapering, mutual fund flows, stretched credit ratings, potential pick-up in M & A activity besides growing share buy-back activity.

Citi analsysts suggest corporates can afford to be more aggressive with their balance sheets, as the probability of default is quite low in the current environment.

However, Citi analysts caution one’s strategy should be to avoid getting run over, as multi-year direction for non-financial spreads is likely to be wider from now on or at best would move sideways. Hence, the analysts advise caution by looking out for right signals to disembark from the releveraging train.