Corporate credit spreads have tightened significantly, despite record-high levels of debt and increased insolvency risks
The US corporate business debt-to-GDP ratio has increased rapidly over the past decade, surpassing its historical high in Q1:2020, to circa 75% of 2019 US GDP (euro area business debt-to-GDP is at circa 110%). Moreover, alternative indicators of the leverage of businesses were approaching their highest level in 20 years at the beginning of 2020. According to data from the provider Refinitiv, the ratio of Net Debt to EBITDA for publicly traded US non-financial/non-energy companies was circa 2x as of Q1:2020 from 1.5x in 2015. The following factors could pose a risk to these firms and their stakeholders: i) a historically high level of business debt; ii) tight bank lending standards; and iii) a higher cost of debt (both bank and market-based), particularly among the riskiest firms.
The interest coverage ratio of US corporate businesses remained high in Q1:2020, suggesting room for maneuver vis-à-vis interest repayments from internal resources. However, as the distribution of COVID-19 economic effects remains uncertain, earnings declines will imply significantly lower interest coverage ratios, which could trigger an increase in firms’ default risk. Note that S&P500 bottom-line earnings declined by 14% YoY in Q1:2020, while analyst consensus estimates for full-year 2020 EPS growth are circa -20%. For euro area businesses, consensus estimates for full-year 2020 EPS growth are circa -26%. Finally, Investment Grade and Speculative Grade cost of debt has increased materially.
Data from the April 2020 Federal Reserve SLOOS indicate that a significant share of US banks tightened standards on commercial and industrial loans in the first quarter of 2020 (net percentage of reporting banks is 40%). While bank loans represent only 15% of US corporate debt, this development, if sustained, could pose additional headwinds to the external financing process of US firms. On the other side of the Atlantic, euro area banks’ credit standards for loans to enterprises tightened only modestly in Q1:2020 (net percentage of reporting banks at +4% following +1% in Q4:2019). Note that the degree of tightening was very modest compared with 2008 (+60%) and 2012 (+30%), albeit euro area banks appeared reluctant to fully evaluate the effects of COVID-19 relative to companies’ credit risk.
The aggressive monetary policy response, particularly in the US, has lessened dislocations in credit markets, partially offsetting the March sell-off. Note that the Federal Reserve, via its corporate credit facilities, could purchase single-name bonds, as well as shares in Investment Grade ETFs and a limited amount of shares in High Yield ETFs with a potential firepower of up to $750bn both in the primary and in the secondary market [actual purchases so far in the secondary market: $0bn]. On the other side of Atlantic, the ECB has stepped up its investment-grade rated corporate bond purchases in the past few weeks by EUR 5bn. This brings its total purchases to EUR 27bn Year-to-Date, as the PEPP (announced on March 18th with a maximum amount of EUR 750bn) opens the door for circa EUR 130bn of additional corporate bond purchases based on the historical CSPP (Corporate Sector Purchase Programme) /APP (Asset Purchase Programme) allocation key, on top of the EUR 200bn actual purchases since the CSPP was introduced. All in, US IG corporate bond spreads have recovered a significant portion of their Covid-19 related widening, with the riskier spectrum still lagging (see graph below). On a weekly basis, credit spreads rallied due to investors’ risk-on mode and higher oil prices, with USD Investment Grade down by 23 bps to 197 bps (EUR: down by 12 bps to 184 bps) and USD Speculative Grade down by 72 bps to 706 bps (EUR: down by 43 bps to 616 bps).