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When The Cycle Turns: Leverage Continues To Climb--Has It Finally Peaked?


When The Cycle Turns: Leverage Continues To Climb--Has It Finally Peaked?

U.S. corporate leverage continues to climb, with the amount of debt that U.S. corporate borrowers are carrying on their balance sheets at an all-time high. This record leverage makes speculative-grade borrowers more vulnerable to downgrades and defaults, when the credit cycle turns.

Debt-to-EBITDA and funds from operations (FFO)-to-debt ratios are just two of the measures S&P Global Ratings uses to calculate leverage among borrowers we rate (see “Corporate Methodology: Ratios And Adjustments,” published Nov. 19, 2013). And while we take into account sector-specific factors such as earnings volatility when determining a borrower's stand-alone credit profile (SACP), the fact remains that as of Sept. 18, leverage across the rated universe of more than 2,300 U.S. nonfinancial corporate borrowers is at a historic high. We believe the risks attributable from this debt binge are significant, given excessive leverage can leave a company more vulnerable to disruptive business conditions and rising financing costs.

Given where we are in the credit cycle, there are concerns about how and when prevailing conditions will turn. Such a change could spark bouts of strong volatility, and periods of rapidly rising financing costs and illiquidity--limiting borrowers' financial flexibility--giving rise to increased defaults.

This isn't to say that adding leverage doesn't come with some benefits. In turn, a significant amount of debt proceeds have been used post-financial crisis to fund mergers and acquisitions (M&A), capital expenditures, and other strategic business initiatives that in many cases have benefitted margins and revenue stability. In addition, debt issuance proceeds over the past several years has been used to gain market share, grow top- and bottom-line earnings, and supplement organic revenue growth challenges.

As a result however of this debt binge, the median debt level among rated U.S. corporate borrowers now exceeds comparable metrics immediately prior to the most recent financial crisis (see charts 1, 2, and 3). Many companies have borrowed opportunistically, taking advantage of some of the lowest interest rates the U.S. has ever seen.

Chart 1

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Chart 2

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Fueled by the potential for rising benchmark borrowing costs, companies have aggressively refinanced and locked into long-term fixed rates. Though a good amount of this debt has been used to fund capital expenditures and M&A, less productively, a significant amount has also been used for shareholder-friendly activities such as buybacks and dividends. However, although buybacks continue to rise, the amount of debt associated with such activities may actually be declining given the recent corporate tax reform bill.

Chart 3

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The Tax Reform Bump Won't Last Forever

With the recent passage of comprehensive corporate tax reform, issuers enjoyed a slight bump in one of our key leverage metrics, free operating cash flow (FOCF), to debt starting in 2017 (see chart 3). In turn, given the fact that future overseas earnings and corresponding cash can now be tapped without an incremental tax, debt issuance to synthetically repatriate once untapped foreign cash piles could decline.

Furthermore, tax reform has mainly favored investment-grade borrowers, which typically had higher tax rates, spend more on capital expenditures, have higher interest coverage ratios, and larger overseas cash piles. Altogether, investment-grade issuers benefited more than their spec-grade counterparts in improving their FFO metrics, with the median investment-grade issuer seeing FFO to debt increase nearly 2% last year, with the median spec-grade issuer seeing the same metric fall by the same amount (2%). (See chart 5 and 8).

Although tax reform has provided a recent uptick in some metrics, the longer-term trends incorporate only a modest delevering effort from a rated issuer perspective (see charts 1 and 2). The question remains: as rates rise, and the credit cycle turns, will these companies be able to reduce their reliance on capital markets to combat periods of volatility? Without stronger delevering, particularly among spec-grade issuers (see chart 7), many companies heavily reliant on the capital market may find more discerning risk-averse investors, forcing borrowers to pay up or even cancel transactions.

Is The Credit Cycle About To Turn?

With spreads still at multiyear lows, modest global economic growth, and the Federal Reserve unwinding its massive balance sheet, this raises the question: Is the current credit cycle at an inflection point? Although, even as we have seen a dramatic rise in amount of debt companies have added, we haven't seen a material deterioration in debt service coverage (i.e., interest coverage, EBITDA, and FFO metrics). In short, low financing costs have enabled borrowers to increase aggregate debt levels while not substantially eroding their debt-service capacity.

Often, a company's earnings prospects are constrained by GDP growth. On the bright side, U.S. economic growth has been gaining momentum. And yet, many borrowers continue to struggle to grow earnings commensurate with their debt binge, adding to overall leverage, especially in the non-investment-grade space.

Since the financial crisis, debt-servicing capabilities haven't experienced material erosion and, in fact, have remained relatively consistent. However, there are pronounced differences between the investment-grade and spec-grade asset classes. (Keep in mind that roughly two-thirds of the U.S. corporate rating universe for S&P Global Ratings is spec-grade, while approximately two-thirds of rated nominal dollar-denominated debt is investment-grade.) Among higher-rated borrowers as a whole, there has been little change in key credit metrics and in fact, interest coverage on both the EBITDA and FFO side have improved somewhat (see charts 4 and 5). This is because companies have opportunistically tapped the capital markets to refinance their debt, pushing out their respective maturity wall, while at the same time reducing their interest costs. As such, they should be better situated to withstand a pronounced downturn in the credit cycle.

Chart 4

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Chart 5

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Chart 6

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Spec-grade credits aren't as well-positioned, generally speaking, having reached peak leverage ratios and suffering modest deterioration in interest-coverage ratios (see charts 8 and 9). Even as most aggregate dollar-denominated debt in the nonfinancial corporate space sits at the investment-grade level, spec-grade debt issuance has exploded in the past three years. As investors have and continue to hunt for yield, non-investment-grade companies previously unable to tap the capital markets have been opportunistically able to do so, and with great reception.

Chart 7

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Chart 8

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Chart 9

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Against this backdrop, some areas of stress have however emerged. Initially, most of this stress was felt in the commodities sector, which has now passed that unenviable torch to the retail sector. Even as we head into 2019, both of these sectors need significant access to capital markets to meet upcoming maturities, which doesn't take into account future issuance needs associated with capital expenditures, budgetary gaps, and permanent working capital. (See "When The U.S. Credit Cycle Turns, Some Sectors May Hit A (Maturity) Wall," published Sept. 20, 2018.)

If defaults rise, so will investors' risk-aversion, which may push them away from lower-quality spec-grade assets. We believe further stress is to come, potentially exacerbating issues for both market liquidity and, perhaps more importantly, funding liquidity. If buyers of corporate loans--including collateralized loan obligations (CLOs)--dial back their risk appetites, the remaining lenders could become more discriminating in their credit-selection process, which could lead to increased funding vulnerability, especially for weaker spec-grade borrowers and those in stressed sectors. Even without a more risk-averse credit environment, rising interest rates can lead to higher funding costs and potentially reduced capital-market access, particularly for lower-quality borrowers.

Certain Sectors Suffer More

While leverage is rising on the whole, some segments are seeing faster increases than the overall market. As expected, industries sensitive to commodity-pricing pressures--e.g., oil and gas, and metals and mining--have experienced material increases in key leverage metrics, but have since seen some significant deleveraging arising from the rebound in commodity prices.

Unfortunately, the shifting dynamics in the retail sector has resulted in an overall escalation in leverage. Particularly vulnerable are retail noninvestment-grade issuers confronting transformational changes and as a result are facing increasing difficulties in the capital markets (see "Stressed And Distressed Retailers: Looking Forward (Or Down) Past The Tipping Point," published Feb. 27, 2018). Defaults have increased, spurred by shifting purchasing preferences and ongoing disruptive pressures.

So while leverage across the rating spectrum is approaching a historical highpoint, it isn't the sole definer of stress for a sector. However, it can constrain financial flexibility, especially in downside scenarios. In this light, external events and conditions--such as the ongoing China U.S. trade dispute, the Federal Reserve's interest-rate normalization (which can rapidly bring about deteriorating credit situations), and rising global geopolitical tensions--make highly leveraged companies potentially most vulnerable.

Related Criteria And Research

Related Criteria
  • Corporate Methodology: Ratios And Adjustments, Nov. 19, 2013
Related Research
  • When The U.S. Credit Cycle Turns, Some Sectors May Hit A (Maturity) Wall," Sept. 20, 2018
  • Stressed And Distressed Retailers: Looking Forward (Or Down) Past The Tipping Point, Feb. 27, 2018

This report does not constitute a rating action.

Primary Credit Analysts:Jacob A Crooks, CFA, New York (1) 212-438-3183;
jacob.crooks@spglobal.com
David C Tesher, New York (1) 212-438-2618;
david.tesher@spglobal.com

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