Record low borrowing costs were not enough to prevent a slide in U.S. companies' ability to service their debts in the first half of 2020.
The average interest-coverage ratio at U.S. companies classified as investment-grade by S&P Global Ratings declined to 5.48 in the second quarter from 5.65 in the first quarter and 6.32 at the end of 2019. For non-investment-grade companies, the ratio — calculated by dividing earnings before interest and tax, or EBIT, by the cost its debt-interest payments — was 2.6 in the second quarter, up from 2.4 in the first quarter, but down from 2.8 in fourth quarter 2019.
The declining ratios reflect a slump in earnings as the coronavirus pandemic ravaged the U.S. economy: average earnings per share across the S&P 500 fell 33.3% year over year in the second quarter. The relatively small decline in interest-coverage ratios is because the Federal Reserve slashed its benchmark rate from 1.5%-1.75% to 0.0%-0.25% in March.
That helped push down the average cost of borrowing for investment-grade U.S. corporates to a record low in June after spiking in the early days of the pandemic. The yield-to-maturity on the S&P 500 Investment Grade Corporate Bond Index, which was at 2.10% in early March, rose as high as 4.20% later in the month. It has since fallen as low as 1.74% in August and was at 1.95% on Oct. 5.
"In [the first half of] 2020, those interest coverage ratios have declined even though the Fed [funds rate] was going to close to zero," Evan Gunter, director at S&P Global Ratings, said in an interview. "What we're looking for primarily is economic growth to rebound and revenues to recover."
Some sectors have been hit harder than others. Investment-grade consumer discretionary companies had been among the best-positioned sectors pre-pandemic with an interest coverage ratio of 11.2 in the fourth quarter of 2019. Successive declines of 25% in the first quarter and 34% in the second quarter have resulted in the ratio halving to 5.6.
The consumer discretionary sector, which includes hotels, retailers and restaurants, has been particularly hard hit by the pandemic. The sector leads in the number of bankruptcies among large U.S. companies this year. Of the 509 bankruptcies tracked by S&P Global Market Intelligence through Oct. 4, 102, or 20%, were from the consumer discretionary sector.
The energy sector has also performed badly by this metric. Its interest coverage ratio, at 4.58 among investment-grade companies, was already among the weakest heading into the pandemic. By the end of the second quarter, it had fallen to 2.42, meaning that almost half its companies' earnings were spent servicing debt.
Energy companies made up 11.6% of the U.S. bankruptcies tracked by S&P Global Market Intelligence this year, third after industrials.
Among the sectors with stable or improving interest-coverage ratios this year are healthcare, which rose from 8.44 to 9.84, consumer staples, which increased 7.89 to 8.50, and information technology, which slipped from 11.76 to 10.01.
The sector with the lowest interest-coverage ratio in the second quarter was real estate with 1.96, but that is only slightly lower than its historical average of just over 2. Real estate is a high-leverage business, but revenue streams are generally stable as landlords work with 5-, 7- and 10-year lease structures, helping them through the economic disruption. Utilities have a similarly low ratio, 2.49 for investment-grade and 1.81 for non-investment-grade, but like real estate have a dependable stream of income, with bills typically the last expenditure to be cut by households.
Financials enjoys the highest ratio, at 10.42, little changed from its historical average.
Falling interest-coverage ratios have contributed to a drop in creditworthiness, a particular concern to companies rated just above investment-grade.
Globally there have been 41 fallen angels — companies that have been downgraded from investment-grade to non-investment-grade — so far in 2020 with 19 of them in the U.S., whereas S&P Global Ratings downgraded just 22 companies in total in 2019. S&P noted in a recent report that the final 2020 total is on track to beat the 2009 record of 57 global fallen angels.
The downgrades in the U.S. mean a combined $252 billion of rated debt has fallen into the high-yield segment.
However, the worst may already be over for those companies on the verge of a so-called junk rating.
There was just one addition to fallen angels in August, the lowest since April, while five companies were removed from the potential fallen angel list between July and August.
Among the companies S&P has listed as potential fallen angels, the proportion considered to be at immediate risk of downgrade fell to 11% in August from 13% in July, and is considerably lower than the five-year high of 27% in April.
"The Fed’s policies have certainly helped ensure that there is enough liquidity to keep investors from being overly concerned about the balance sheets of long-term viable companies," Anik Sen, global head of equities at PineBridge Investments, said by email.
"Investors are still concerned about the balance sheets of leveraged companies that are heavily impacted by the pandemic, especially those that that had weak business models heading into the pandemic. Bankruptcies and credit downgrades are still occurring for these types of companies," Sen wrote.