For the investment grade credit market, the first three quarters of 2020 can be characterized as nothing short of unprecedented. The COVID-19 pandemic and the subsequent shock of an economic shutdown forced many companies to operate with uncertain supply and demand outlooks, forced others to reevaluate their business plans and forced all companies to assess their liquidity profiles. While quick and aggressive central bank policies allowed companies to alleviate near-term liquidity concerns, management teams are beginning to formulate their post-virus business plans. The outcomes of these plans will vary as not every industry or company has been impacted by the virus in the same way or to the same degree. However, individual corporate responses should ultimately determine who is better positioned to thrive and who could falter as the economy rebounds.
Companies Have Played Defense
Since the start of the pandemic, companies have been playing defense by cutting costs, delaying or canceling expenditures and utilizing accommodative capital markets to issue record levels of debt. Debt issuance trends illustrate this behavior as U.S. investment grade corporate issuance as of the third quarter is tracking at $1.4 trillion, up 80% compared to the first nine months of last year (see Figure 1).
Figure 1: U.S. Investment Grade Corporate Issuance
Source: Barclays. As of September 30, 2020. Excludes non-corporates.
Issuance proceeds were used primarily to build cash reserves or to refinance and extend near-term debt maturities. Cash flows declined and gross leverage increased, resulting in an overall deterioration in credit fundamentals. However, the deterioration was tempered by the more moderate rise in net leverage and increase in cash balances (see Figure 2).
Figure 2: U.S. Corporate Debt Ratios and Cash Levels
Source: Bloomberg; Data is S&P 500 ex-financials.
Management teams are exiting the short-term response phase that dominated the first half of the year and are thinking more strategically about the medium to long term, including how to best address any short-term or long-term structural industry changes. Generally, we expect a gradual shift in mindset from defense to offense, tempered somewhat by the uncertainties that persist around COVID-19 and potential policy changes after the election.
Management Teams and Boards Have Been Compelled to Act
In our view, recent mergers and acquisitions activity is evidence that decision-making processes in the C-suite are already leading to action, as equity valuations have dislocated and funding costs remain low. In some cases, strategic decisions that were delayed by COVID-19 uncertainty are being moved forward. In other cases, COVID-19 has accelerated sector trends and equity valuations have shifted, making certain mergers and acquisitions more financially attractive and strategically necessary in some cases.
These behaviors are being seen across and within sectors (see Figure 3). For example, in technology, IBM is finally spinning out its low-growth infrastructure services business to accelerate growth in core IBM operations as the new CEO addresses long-term growth issues. This action was likely put on pause due to COVID-19 uncertainty but was finally announced in October. In terms of an accelerated deal, Nvidia’s $40 billion acquisition of Arm Limited, announced in September, is a prime example as Nvidia uses its equity as currency that has more than doubled year-to-date due to strong cloud and gaming sales: two markets benefitting from COVID19 trends. Within the energy sector, economic stress is resulting in consolidation as demonstrated by the Chevron/Noble, Devon/WPX and ConocoPhillips/Concho deals. Depressed oil demand has seemingly caused smaller players to reevaluate long-term prospects as a standalone company, choosing to combine with larger peers to benefit from scale and diversification.
M&A is expected to continue following depressed levels of activity early in the pandemic. Contrary to conventional views, we believe the early part of the M&A cycle is a sign of a healthy market and are more likely to be in a spread tightening environment. This has been reinforced by most deals being funded with a large equity component as balance sheet conservatism is prioritized, at least for now. However, not every deal will be a success, highlighting the importance of understanding strategic merits of transactions and the future industry dynamics.
Figure 3: M&A in the Current Climate
Source: Neuberger Berman.
Corporate Behavior Will Likely Vary Across and Within Sectors; Range of Outcomes Could Be Wide
In our view, recent M&A transactions are likely just the start of corporate actions that could occur as a result of the short- and long-term impacts of COVID-19. Across and within sectors, we have developed a framework for thinking about the wide variety of corporate responses to both the short- and long-term structural industry changes. Specifically, we expect companies to broadly fit into one of the four categories: (1) capitalize, (2) revert, (3) adapt, and (4) surrender.
Figure 4: Virus Impact On Corporate Behavior
As a result of COVID-19, the operating environment is changing and companies are responding
Source: Source: Neuberger Berman.
Companies in this category are well-positioned to play offense, which could take several forms:
Gain market share and accelerate organic growth. Pre-COVID, these companies had strong operations, technological capabilities and supply chains. Attractive cash-flow generation, healthy balance sheets and conservative financial policies enable a swift shift to offense. For example, companies within the telecom and cable sector are well-positioned to capitalize on the trends of increased broadband usage in the working- and learning-from-home environment. In the consumer products sector, the focus on at-home activities, trusted brands and cleanliness has rejuvenated legacy businesses that were otherwise facing challenges, providing an opportunity for companies to invest back in the business and gain market share. In the technology sector, hybrid working and learning, and a surge in e-commerce should benefit organic growth for cloud, software and payments companies.
Improve debt maturity profiles and lower interest expense. Capitalizers had no issues with capital-markets access this year. These issuers can continue to be opportunistic when thinking about capital structures to term out debt maturity profiles and lower all-in interest expense. For example, issuers such as AT&T, Comcast and Verizon have taken advantage of the current strong technical environment to opportunistically term-out debt maturity profiles and lower all-in coupon rates.
Pursue M&A using equity and debt. Strong equity performance is another likely attribute of companies in this category, potentially leading to an increased willingness to use equity as currency for M&A. Many of the recent M&A deals have involved a large equity component, limiting negative credit impacts. However, we would expect that many of the market leaders, who in many cases have single-A ratings, will be revisiting the cost/benefit of maintaining such strong ratings. Adding debt to balance sheets and moving from single-A to BBB ratings, but still within investment grade, could make sense for the right strategic acquisition.
Companies within this category are not seeing material changes to industry dynamics due to COVID-19 that warrant a change in business model. The short- and long-terms trends due to the virus have not shifted the industry landscape. For example, historically defensive sectors such as utilities likely will revert to their pre-COVID-19 business model and financial policy. Similarly, we would expect companies that are accustomed to operating through economic cycles to continue this behavior. For example, the metals and mining sector has operated through various supply and demand environments and the current cycle is no different. There is nothing unique about the COVID-19 events specifically that requires a major adjustment to operational activities or capital allocation decisions.
Companies in this category have seen material shifts in industry fundamentals that could persist over the long term. This could require adapting business models to remain competitive and adjusting financial policy to maintain credit quality, if desired. For example, certain food and beverage companies that were facing secular declines in their branded products likely have seen a resurgence of demand for trusted brands as increased at-home consumption is expected to persist to a degree over the long term. This has helped to improve top-line growth, profits and cash flow, providing an opportunity to reduce debt and kickstart deleveraging from debt-financed M&A of years past. Large restaurant companies such as Starbucks and McDonald’s are adjusting to lower on-premise consumption, focusing on alternative consumption touch points such as drive-thru and delivery. In both cases, management teams have prioritized to debt reduction and paused share repurchases to preserve credit quality.
Companies in this category can become “capitalizers” if they have strong assets and adept management teams who make the right strategic decisions at this critical time. However, business models need to evolve, and improvement is needed in areas such as supply chain and cost structure. Many of these companies likely were caught off guard earlier in the year as it relates to capital markets access, having to pay more for liquidity. Some companies likely found themselves with too much leverage for current credit-rating goals given debt increases and profitability declines. Now, management teams and boards can change financial policy to be more conservative or aggressive. There will likely be conflicts as decision makers consider equity holder interests versus bondholder interests. We expect to see a large range of outcomes in this category over the long term as it relates to winners and losers from an operational and credit perspective. Management team quality will be a key driver of these outcomes.
Sectors that were acutely impacted by the virus such as lodging and leisure fit squarely into this category. Industries facing widespread capacity rationalization due to demand weakness, such as energy, also have companies in this category. In other cases, industries that were already plagued by secular changes saw these trends accelerated by COVID-19. For example, as COVID-19 accelerated the shift from in-store to online and differentiated essential versus nonessential retailers, department store retailer business and credit fundamentals have deteriorated. Fallen angels in this subsector have accelerated as business models are questioned and credit metrics are out of line with investment grade ratings with Macy’s and Nordstrom as recent examples.
Low-quality management teams without winning strategies will likely be overwhelmed by industry pressures. In many cases, the result could be deteriorating credit metrics and ratings pressure. In other cases, companies will seek buyers, shrink businesses or pursue M&A. Not all outcomes will be credit negative, but in our view event risk overall is elevated across this category.
A Key Differentiator
Corporate Behavior in the Post-COVID-19 Economy Will Likely Be a Differentiating Factor Between Winners and Losers Over the Long Term. COVID-19 economic impacts have reshaped sectors as new trends form and pre-existing ones accelerate. The corporate response categories to these changes as detailed above provide a framework for thinking about corporate decision making in the evolving landscape. Outcomes across and within sectors will likely be divergent. There will be A-rated “Capitalize” companies that are more aggressive with financial policy and fall to BBB, and not all “Surrender” companies will end up fallen angels. However, a sharp focus on sector fundamentals and identifying winners and losers will be increasingly important as the post-COVID-19 economy takes shape. Governance will be a differentiating factor as more experienced, higher-quality management teams and boards are better positioned to implement winning strategies. While the Federal Reserve’s bond purchase program has been supportive of the investment grade corporate market and we expect technicals to remain attractive, while fundamental analysis to differentiate between winners and losers has the potential to win out over the long term.