Are There Cracks In The Credit Market? by Kirk Moore, Columbia Threadneedle Investments
- Record new debt issuance, lack of revenue growth, increased acquisition activity, and the re-emergence of debt-financed shareholder returns have caused deterioration in credit metrics.
- Corporations may not be as close to the end of their credit cycle as the deterioration in credit metrics would imply.
- Much like the failures of over-levered U.S. consumers were the catalyst for the last credit cycle, evidence is mounting that over-levered governments are the possible tail that wags the dog.
A recent article on Bloomberg highlights a growing concern that we are reaching the end of the corporate credit cycle. Record new debt issuance, the lack of revenue growth, increased acquisition activity, and the re-emergence of debt-financed shareholder returns have combined to cause deterioration in average credit metrics. Credit investors are correct to be concerned. Layer on top the reduction in bond market liquidity seen by many as a red herring to tighter credit availability, and it is hard to argue against the idea that the end of the expansion phase of the corporate credit is near.
While declining credit metrics are a concern, are corporations really overextended? Exhibit 1 shows that, at 4.7x, high-yield leverage on average has jumped to an almost 20-year high.
Exhibit 1: High-yield leverage has jumped to a near-20-year high
Source: Columbia Management Investment Advisers, 07/15
The culprit for the half-turn (0.5x) increase in average leverage in the first quarter of 2015 is not a ramp up in debt, but a decline in earnings. The change in debt, while increasing, was in line with last seven quarters, while the EBITDA change was decidedly negative. The primary culprit was a -131.7% decline in energy EBITDA.
A similar pattern can be seen for average investment-grade leverage metrics; the shape is quite similar to high yield. Looking at the industry components tells a similar story. Industrials are flat to down over the decade, while energy average leverage is up over 1.0x since 2011. A conclusion is that not all industries are witnessing meaningful declines in credit metrics.
Exhibit 2: Investment-grade leverage shows a similar increase, driven by Energy
Source: Columbia Management Investment Advisers, 07/15
Corporations may not be as close to the end of their credit cycle as the deterioration in average leverage would imply. Exhibit 3 indicates that both gross leverage and interest coverage are trending up. This is normally and intuitively an inverse relationship. As leverage increases, so does interest expense, and thus earnings coverage of interest expense drops. However, since 2010, interest coverage has increased along with leverage. At the same time, corporations have recently taken advantage of low interest rates to extend debt maturities. This demonstrates that, to date, corporations have been reasonable in managing the capital structure, arguing that the end of the corporate credit cycle will not be self-inflicted.
Exhibit 3: Gross leverage vs. interest coverage – historically, an inverse relationship…until recently
Sources: Morgan Stanley Research, Bloomberg, 07/15
The forecasters of corporate defaults currently agree. On an issuer-weighted basis for 2015, Moody’s and S&P see 2.7% and 2.8%, respectively. On a par-weighted basis, JPMorgan is calling for 3.0% in 2016, up from 1.5% in 2015. Our U.S. high-yield research team’s estimates call for 3.6% in 2015 and 4.9% in 2016 on a par-weighted basis. This is an increase from 2.6% and 3.3%, respectively — estimates made in September 2014 that were driven almost entirely by Energy.
But it is not all clear sailing. While some companies have been reasonable stewards of capital, others have not. Much like the failures of over-levered U.S. consumers were the catalyst for the last credit cycle, evidence is mounting that over-levered governments are the possible tail that wags the dog. A catalyst for the recent decline in oil was Saudi Arabia’s realizing the need to maintain market share to support longer term social expenses. The recent decline in other hard commodities is related to demand-driven concerns as the market questions Chinese policymakers’ ability to manage a ‘social capital market.” Eleven rate cuts followed by what appears to be a deflating of the equity market margin bubble does not support China adding to incremental commodity demand.
Also, of the 69 countries that we follow, 74% of the governments have witnessed an increase in debt as a percentage of GDP since 2008. A number of these countries have commodities as their main exports as well as a mixed record on market-pleasing financial reform. Are Greece and Puerto Rico anomalies, or will politicians and policymakers come to the realization that hard choices are necessary before their backs are against the wall? Unlike U.S. corporations, evidence suggests that some policymakers did not take the opportunity afforded by low U.S. and developed eurozone rates.
