US companies' ability to repay their pandemic debt piles is getting easier

It is getting easier for U.S. companies to repay the debts they racked up over the course of the COVID-19 pandemic.

The median interest coverage ratio — a measure of a company's ability to repay its debts calculated by dividing earnings before EBIT by the cost of its debt-interest payments — rose to its highest level in two years in the fourth quarter of 2020. U.S. investment-grade companies were able to cover the cost of interest payments seven times over for the three-month period. That is up from a low of five times in the second quarter of 2020 and better than the six times seen in the fourth quarter of 2019, according to S&P Global Market Intelligence data.

Corporate America undertook a deluge of borrowing in 2020 to secure itself in the face of lost revenues as COVID-19 reached U.S. shores. Investment-grade rated companies issued a record $1.687 trillion of bonds — a 59.7% increase year over year.

The median debt-to-equity ratio — a closely watched measurement of corporate leverage determined by calculating total liabilities as a percentage of shareholder equity — of U.S. investment-grade companies was 99.4% in the fourth quarter of 2020, up slightly from 99.1% in the previous quarter, and 6.5 percentage points higher than a year earlier.

Taking note of the improving outlook for companies after the worst of the pandemic, S&P Global Ratings is promoting more companies to investment grade from noninvestment grade in 2021 than vice-versa.

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While the median debt-to-equity ratio of investment-grade companies is lower than the 106.2% peak seen in the first quarter of 2020, it remains higher than the pre-pandemic level. But if companies are concerned about debt levels they are not showing it.

"Corporate fixed-income markets have seen a sharp increase in new issue supply. This can be largely attributed to issuers fast-tracking their future issuance to lock in what are still very low funding costs," Andrea Iannelli, investment director at Fidelity International, said in an email.

Bond issuance of $422.21 billion in the first quarter of 2021 was the second-highest January-March total ever behind the COVID-19 inspired glut in 2020.

The environment parallels the aftermath of the 2008 financial crisis when companies issued more debt in a low-rate environment, said Christopher Rossbach, manager of the J. Stern & Co. World Stars Global Equity Fund.

"In terms of defaults, however, we are in a much more subdued environment now than we were during the last global financial crisis, as recent market data has shown," Rossbach said.

Cheap credit

While bonds were issued to raise capital at the beginning of the health crisis, the priority of issuance today is to refinance at lower rates or raise funds for M&A or share buybacks.

Borrowing costs are historically low and seem likely to remain that way in the near term. The Federal Reserve has no plans to raise interest rates from the current 0% until 2024 at the earliest and has not indicated that it will begin to taper its $120 billion a month asset-buying program any time soon.

Borrowing costs in bond markets have dropped as a result of these measures. The S&P U.S. Investment Grade Corporate Bond Index was yielding 2.01% as of April 22, from a peak of 4.23% in March 2020 before the Fed's actions took effect.

The depth of the monetary support meant companies with lower credit ratings also improved their balance sheets. The interest coverage ratio of companies rated BB+ and lower by S&P Global Ratings was up to 3.1 in the fourth quarter of 2020 from 2.8 a year earlier.

While the ease with which companies can service their debts is currently a result of supportive monetary policy, the economic recovery should allow companies to wean themselves off the Fed's support lines.

"After a year of constrained mobility, households have become a $2 trillion source of cash. Yes, the Fed can start to take away its punchbowl, but the economy and markets have other sources to stay liquid," said Jason Draho, head of Americas asset allocation at UBS Global Wealth Management.

Fewer fallen angels

The strengthened financial outlook for corporate America is reflected in the decisions by Ratings.

The number of rising stars — companies promoted to investment grade from noninvestment grade — has outpaced the number of fallen angels — companies downgraded to noninvestment grade from investment grade — by five to two in 2021.

This marks a sharp reversal from 2020 with the $38.5 billion of rising star debt already exceeding the 2020 full-year total.

Meanwhile, the total number of potential fallen angels in the U.S. and Europe, the Middle East and Africa has fallen to 55 from a peak of 76 in June 2020.

"Much of the decline is attributable to outlook revisions to stable in sectors that are faring better than expected or that stand to benefit from the emerging recovery," Ratings analysts wrote in an April 14 research note, noting that the biggest improvements in potential fallen angel debt have been in the oil and gas and midstream, consumer products, automotive, and metals and mining sectors.

Consumer sectors

Consumer-facing companies were among the hardest hit by the pandemic as the inability of households to spend in shops and restaurants forced them to borrow heavily.

Investment-grade retail companies issued $52.75 billion of bonds in 2020, up from $12.65 billion in 2019, according to LCD, an offering of S&P Global Market Intelligence. It was a similar story for automotive groups, which issued $18.55 billion of bonds, up from $5.75 billion.

The consumer discretionary sector had the second most elevated debt-to-equity relative to a year earlier in the fourth quarter of 2020 after energy with the median ratio of the investment-grade segment at 137.7%, up from 118.1% a year earlier. However, this was down from a peak of 179.8%.

Yet the median interest coverage ratio for consumer discretionary companies rose to 13.8 in the fourth quarter of 2020 — up from 12.0 a year earlier — and with vaccines rolling out and stimulus checks reaching consumers' pockets, discretionary spending is increasing.

Households will also contribute to sustaining liquidity in financial markets as savings in bank deposits find their way into financial markets searching for income, Iannelli of Fidelity noted.

"As long as that [liquidity] remains in place, yields will remain in check, helping corporates refinance their debt stack and lower their overall cost of capital," Iannelli said.