With corporations shunting more of their earnings toward paying interest and paying down debt, they will struggle to hire and invest as much as they would at the end of a more conventional recession, said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. That could translate to a relatively sluggish recovery instead of the fast, “V-shaped” one many investors hope for.
“The debt overhang is going to be a headwind for capital spending and for hiring, not just in the second half of the year but probably into next year as well,” Feroli said.
Lower Yields
Anheuser-Busch InBev NV is rated investment grade but had a net leverage ratio in the second quarter of nearly five, a level more commonly associated with junk ratings, as demand for its beer fell in bars and restaurants. At the end of 2019 that ratio was a still-high four, and the company had been trying to cut it to closer to two times. AB InBev’s debt load swelled after its massive acquisition of rival SABMiller Plc in 2016.
With short-term interest rates having fallen to near-zero levels, borrowing is cheaper for most companies than it was just a year ago. Average yields on U.S. investment-grade corporate bonds touched all time lows of 1.82% earlier this month, and are still hovering near those levels, according to Bloomberg Barclays index data.
But companies still have lower earnings relative to their required interest payments. The ratio of their earnings before interest, tax, depreciation and amortization to their interest expense, known as their interest coverage, fell to 5.8 in the second quarter for investment-grade companies, compared with a 20-year average closer to 7. The June 2020 level was the lowest since 2003. For junk-rated companies, the interest coverage ratio fell to 2.3 in June, also the lowest since 2003.
Ratings firms are taking note of the broad downward trend in credit quality. S&P Global Ratings downgraded more U.S. high-yield debt in the second quarter, relative to upgrades, than any time in at least a decade, according to data compiled by Bloomberg.
Credit metrics have been eroding despite some evidence that the economy is stabilizing or even recovering. As of Thursday, more than 80% of the S&P 500 companies that posted second quarter results performed better than analysts’ average expectations, according to Bloomberg Intelligence data.
Even with that improvement, the economy is still weak. Corporate earnings per share fell by about a third in the second quarter from the same period last year, and are likely to fall in the third and fourth quarters as well. Debt loads are also higher, and strategists expect leverage and interest coverage to erode further.
Liquidity, Solvency
Some of the worst credit deterioration has happened for transportation companies, which have suffered as customers have stayed home. For junk-rated companies, leverage in the transportation sector jumped to a staggering 10.77 times for the second quarter, up from 5.24 times in the first quarter, driven largely by the airlines.
The consumer cyclical sector also saw a large increase in leverage ratios, to 7.51 from 5.29 in the first quarter, driven in part by cruise lines and the fall of Ford Motor Co. into junk.
Investors have given companies a break for about a year and are looking ahead into mid-2021 or later to evaluate where they will perform after, for example, the world finds and distributes a Covid-19 vaccine. That explains why cruise companies that are burning cash, such as Royal Caribbean Cruises Ltd. and Carnival Corp., have been able to borrow repeatedly, and have seen most of their new bonds trade well above the price at which they were originally sold.
But even if bond prices are broadly rising, investors need to be cognizant of the risks they’re buying, said Schwab’s Jones.
“This cycle is very different because we’ve had so much support from central banks and we have so much liquidity in the market,” Jones said. “But the old saying ‘liquidity does not equate to solvency’ is something people need to keep in mind when they’re investing.”
--With assistance from Noel Hebert, Joel Levington, Hoai Ngo, Molly Smith, Davide Scigliuzzo and James Crombie.
This article was provided by Bloomberg News.