Corporate America levered up in 2020 as the coronavirus pandemic threatened revenues. But even with ample cash on hand, companies are likely in no hurry to unwind that buildup of debt.
Borrowing was crucial in the early days of the pandemic as companies made a dash for cash to cover operating expenses. S&P 500 companies held a total of $1.88 trillion in cash as of the third quarter of 2020, according to S&P Dow Jones Indices, leaving them well placed to deleverage. But experts say paying down debt will take a backseat to mergers and acquisitions, capital expenditures and shareholder returns as borrowing costs fall ever lower, buoyed by support from the Federal Reserve.
"Before COVID, the big discussion was U.S. investment-grade corporates already getting very levered and how that was going to play out," said Gregory Venizelos, senior credit strategist at AXA Investment Managers. Venizelos has long warned of an "Armageddon scenario" whereby borrowing costs rise, sparking a wave of debt-laden fallen angels — companies downgraded below investment grade and facing higher borrowing costs. The 24 fallen angels in 2020 were second only to 2009 when 57 companies were downgraded to junk.
"Now we find ourselves with yet more debt," Venizelos said.
Debt and downgrades
The total debt held by U.S. nonfinancial corporations surged in 2020 to a record high of 83.5% of GDP, or $17.544 trillion, in the third quarter from 75.7% at the end of 2019, according to the Institute of International Finance. The sum moderated slightly to 81.8%, or $17.138 trillion, by the fourth quarter of 2020.
A borrowing surge during the low-interest era created after the great financial crisis of 2007-2009 weighed heavily on the credit ratings of U.S. companies that piled on debt during that time. The cash rush sparked by the pandemic only worsened that trend. 58% of total U.S. financial and nonfinancial corporations are rated non-investment grade by S&P Global Ratings, an all-time high. Meanwhile, the percentage of companies rated below B- rose from 17% to 23% over the course of 2020.
Downgrades of U.S. companies reached a record 910 in 2020, up from 483 in 2019 and beating the previous record of 789 in 2009. In the second half of the year, the pace of downgrades slowed sharply on the back of trillions of dollars of government and monetary support for the economy. By the fourth quarter, downgrades in the three-month period were down to 88, following a peak of more than 400 between April and June.
"The ability to borrow was more positive than it was negative, but there is a carry-on effect," Gregg Lemos-Stein, global head of analytics & research at S&P Global Ratings, said in an interview. "The debt hangover will last in many cases a lot longer than the health impact."
For now, refinancing debt is not a problem for many companies as bond yields are at historic lows. U.S. investment-grade bond spreads jumped from about 100 basis points to 401 bps at the March 2020 peak of the panic in financial markets and were back to 94 bps as of Feb. 19, according to the ICE Bank of America Index. Spreads have also returned to pre-pandemic levels in the high-yield market after falling to 341 bps as of Feb. 19 from a peak of 1087 bps in March 2020.
But with some $5 trillion of U.S. corporate debt scheduled to mature between 2021 and 2025, borrowing costs will need to stay low so companies can continue to refinance debt.
The concern is the amount of debt hovering just about junk status. BBB-rated debt accounts for about $3 trillion of the $5.3 trillion investment-grade total.
Blue-chip automotive giant Ford Motor Co. was the most high-profile of 24 fallen angels in the U.S. in 2020, accounting for $113.86 billion of the total $285.015 billion of rated debt that fell into the higher-yielding speculative-grade market. Another 43 companies with a further $281.615 billion of rated debt are listed as potential fallen angels by S&P Global Ratings.
The possibility of a swath of downgrades flooding the high-yield market, where there is less liquidity and investors demand a higher risk premium, worries Venizelos. The "Armageddon scenario" could be triggered by treasury yields pushing above 2.5% with investment-grade spreads 300 basis points wider, though Venizelos acknowledged "that would require a significant repricing from where we are."
Much will depend on the continued easy monetary policy of the Fed. BNP Paribas warns that BBBs will be among the sectors that will underperform when the Fed does begin to taper its quantitative easing program. "Policy tightening is the inevitable outcome as the pandemic recedes and the economy normalizes — it's a matter of time and everyone knows this," Viktor Hjort, global head of credit strategy at BNP Paribas, wrote in a Feb. 12 market commentary.
The Federal Reserve's dovish tone has been crucial for supporting liquidity, particularly in bond markets, which companies tapped at record levels in 2020.
By the end of 2020, U.S. investment-grade-rated companies had issued $1.687 trillion of debt, according to data from LCD, an offering of S&P Global Market Intelligence. The total represented an increase of 59.7% over 2019 and was 35.7% higher than the previous record of $1.243 trillion in 2017.
Issuance for non-investment-grade companies followed a similar trend, reaching $435 billion in 2020, up from $272.6 billion a year earlier and the record of $344.8 billion in 2012.
But while borrowing costs are low on the whole, Lemos-Stein expects sectors that are facing "secular change" will find it more difficult than others to tap markets, and noted that while the projected enormous spike of defaults in 2020 did not occur, "that default curve has been flattened."
S&P Global Ratings expects the U.S. trailing-12-month speculative-grade corporate default rate to gradually climb to 9% in September. The rate was just 3.5% in March 2020.
Of the companies rated by Ratings, the oil & gas sector has the largest negative bias — the percentage of ratings with negative outlooks or on Credit Watch with negative implications — at 62.7%. The sector has suffered under low oil prices and falling out of favor for increasingly ESG-conscious investors. Media/entertainment, at 53.6%, and transportation at 45.8% are the next weakest positioned, as the attack on their business models accelerated as a result of the pandemic.
"It tends to be when industries are facing more pressure — for instance, the newspaper industry — that at some point when they're stable and not growing, a lot of times that’s when you add leverage. But when they're really in a decline mode, that’s when you see leverage declining," Lemos-Stein said.