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Defaults seen dropping as interest-coverage ratios return to pre-COVID-19 levels


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Defaults seen dropping as interest-coverage ratios return to pre-COVID-19 levels

The Federal Reserve has done such a good job of lowering borrowing costs that the average U.S. public company is in a better position to service its debts than before the coronavirus pandemic devastated vast swaths of the country's economy.

The average interest-coverage ratio — a measure of a company's ability to repay its debts calculated by dividing earnings before interest and tax, or EBIT, by the cost of its debt-interest payments — of investment-grade U.S. companies jumped to 6.6 in the third quarter of 2020, the highest level since at least the third quarter of 2018, up from a low of 4.99 in the second quarter of 2020. The ratio had sunk from 6.1 at the end of 2019 as the outbreak morphed into a global pandemic and drained revenues.

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Non-investment grade companies are also better off than they were, according to that metric. They were able to cover their debts 2.96 times over in the third quarter of 2020, up from 2.6 in the second quarter and the low of 2.37 in the first quarter.

While not the only factor determining whether a company will default, the data supports a turnaround in rating agencies' views of forthcoming missed debt payments. In May, as global economies regathered themselves, S&P Global Ratings analysts increased its expected trailing 12-month default rate for U.S. non-investment grade-rated companies to 12.5%, up from just 3.5% in March. By January, Ratings had revised the outlook down to 9% by September 2021, while the rating agency's optimistic scenario was back down to 3.5%.

Defaults by rated U.S. companies totaled 146 in 2020, up from 78 in 2019, and the most since 192 in 2009 in the wake of the global financial crisis.

"The default rates are going to come down for a couple of reasons," Michael Kelly, global head of multi-assets at PineBridge Investments, said in an interview. "One is that only about half the reasons that companies default is actually being unable to cover the interest expense over an intermediate to longer term perspective. The other half is when liquidity dries up and you can't refinance even if you can cover the intermediate repayments," Kelly said.

The actions of the Federal Reserve did much to alleviate both these stresses, cutting the Fed Funds rate by 150 basis points to a range of 0%-0.25% to lower lending costs, and committing to buying corporate bonds to provide a backstop of liquidity that encouraged investors to reenter the credit markets.

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Liquidity was the pressing concern as the crisis struck with companies drawing down $275.14 billion through their revolving credit facilities in March before returning to bond markets, initially to strengthen their cash buffers, then to refinance existing debt at the lower rates afforded by extensive monetary support.

U.S. investment-grade bond issuance totaled a record $1.687 trillion in 2020, compared with $1.057 trillion in 2019.

Companies have been boosted by the decline in borrowing costs. The yield-to-worst on the S&P U.S. Investment Grade Corporate Bond Index was 1.72% as of Jan. 19 after starting 2020 at 2.78% and having been as high as 4.23% in March 2020.

The measures taken by the Fed primarily benefited investment-grade-rated companies through lower spreads, but the benefits of extra liquidity soon trickled down into the non-investment grade world as confidence in credit markets was renewed.

"The fiscal stimulus, Fed back-stop of segments of the credit markets and rock bottom interest rates have likely kept the capital markets open to a much wider segment of companies than in a normal recession," David Lefkowitz, head of equities Americas, said by email.

In the investment-grade universe, sectors that had relatively high average interest coverage ratios ahead of the crisis have seen significant improvements in their ability to repay debt.

Healthcare companies ramped up the ratio to 12.95 in the third quarter having been 9.05 a year earlier, while consumer discretionary rose to 11.6 from 10.5, information technology to 10.3 from 9.2 and consumer staples to 9.3 from 7.9.

By contrast, the investment-grade energy and real estate sectors saw their respective interest-coverage ratios fall to 2.99 in the third quarter from 4.28 and 1.99 from 2.38. The decline was starker in the energy sector, which had a ratio of 6.18 as recently as the fourth quarter of 2018.

Lower down the credit spectrum energy was again the laggard with a ratio of 1.6 in the third quarter of 2020 down from 2.13 a year earlier, whereas consumer staples did the best of the non-investment grade-rated sectors, increasing to 3.57 from 2.4.

"The risks have probably fallen for those that have made it this far. But investors still have to be discriminating," Lefkowitz wrote. "Some businesses may have to contend with more permanent changes in consumer and business behavior that were unleashed by the pandemic. Not all businesses that were negatively impacted by the pandemic may bounce back."