Credit spreads: the big squeeze
We question whether credit spreads reflect current levels of corporate leverage.
In fixed income, it’s not always easy to determine whether we, as investors, are appropriately compensated for the level of risk we are taking by providing liquidity to issuers. Whilst equity investors turn to ratios such as P/E (price to earnings), which is a well documented and accepted metric, credit investors generally look at spread levels in a historical context, to determine the relative attractiveness of valuations.
We became concerned on this front towards the end of last year, as spreads were not too far off their tightest levels of the past 20 years, which was the period before the global financial crisis.
Given the astonishing amount of support from central banks, resulting in over $12 trillion of negative-yielding debt, and ample fiscal stimulus (potentially worth up to 25% of US GDP since the COVID-19 crisis hit last year) it’s not beyond the realms of possibility for spreads to break through those levels in 2021.
However, as primarily investment-grade credit investors, our main concern remains avoiding tail-risk events such as default in very rare cases or downgrades to high yield (known in the market as fallen angels). Therefore, we focus on corporate fundamentals – and in particular leverage (net debt to earnings) – to assess long-term debt sustainability.
Corporate leverage deteriorated considerably in 2020: net debt stayed flat while earnings collapsed as corporates were hit by the shockwaves from the pandemic. However, this deterioration was preceded by years of gradual increases in leverage, as corporates took advantage of falling yields to use the proceeds from newly issued debt for share buyback programmes and to fund M&A activity, which are usually more beneficial to shareholders than bondholders.
When the COVID-19 crisis hit the global economy, credit spreads spiked, reflecting the expected weakening of corporate balance sheets, as well as lower market liquidity. But while spreads have recovered and are now lower than they were at the end of 2019 before the crisis hit, leverage remains elevated. As it is a backward-looking measure, we are yet to see the improvement in earnings in corporate balance sheets.
As a consequence, spreads appear to be stretched (using spread per turn of leverage, which is the average spreads for investment grade and high yield divided by the median net debt to EBITDA ratio). This is shown in the chart below.
Where are we now?
Looking at this chart, do we believe that credit investors are appropriately compensated for the risk they are taking?
• Whilst there is a fair chance that spreads may remain tight for the foreseeable future, we expect leverage figures to peak in mid-2021 and improve beyond that point, providing some relief to the spread per turn of leverage ratio.
• Focusing on fundamentals, but looking at shorter-term drivers and corporate behaviour, we have seen much more conservative approaches to balance-sheet management, with the stockpiling of liquidity, decreases or suspension of dividend payments and share buyback programmes, and reduced M&A activity. We expect corporate activities to revert back to pre-crisis exuberance eventually, but this will take time.
• Finally, while it is true that corporate leverage has been slowly creeping up since the global financial crisis, debt-servicing costs have also remained low, given the attractive yield levels at which corporates have been able to issue and refinance debt.
These three observations, combined with extraordinary support from monetary and fiscal policy, explain why we haven’t moved to a fully defensive positioning despite a more cautious outlook.