Corporate debt is 64% higher than it was on the eve of the financial crisis. But that headline number hides a lot of nuance.
A lot of attention is being directed to investment-grade companies. By 2018, gross leverage in this sector is near its long-term peak of 2.3-2.4x EBITDA, and interest coverage at around 10x is near a post-crisis low, according to Morgan Stanley Research. Almost two-thirds of that outstanding debt matures over the coming five years, potentially putting the sector at risk of rising rates or a spike in risk aversion in the primary markets. Much has been made of the rapid growth in outstanding BBB rated issuance as credit quality has deteriorated in the investment grade universe.
However, it is important to note that financials, the most systemically important sector, has seen its credit profile improve since the financial crisis. And while gross leverage at investment grade corporates is at a 30-plus year high, net leverage is lower than it was around the technology crash of the early 2000s. This tells us that a lot of this debt has been taken on by companies in traditionally defensive, non-cyclical sectors to take advantage of the very low, long-dated interest rates that have been available for the most creditworthy borrowers. Moreover, U.S. corporate debt declined in 2018 as tax-reform proceeds were added to balance sheets, and companies have signaled an intention to de-lever further in 2019.
There are few signs of corporate exuberance in either the U.S. or Europe: M&A and IPO activity remains muted relative to the top of previous cycles, and the level of profits remains modest.
In high yield the picture is mixed. Bond market leverage appears already to have plateaued at 4.0-4.5x EBITDA, back in 2016. It is now heading toward 3x, and interest rate coverage is approaching a post-crisis high, according to data from Bank of America Merrill Lynch. In leveraged loans, however, high valuations in the private equity markets, combined with surging demand from investors seeking floating-rate protection as monetary policy tightens, have been pushing leverage up toward a ratio of 5.5-6.0x EBITDA. Moreover, that debt issuance has been getting more aggressive, coming from lower-rated borrowers, with looser covenants and a smaller high-yield bond cushion in capital structures. A rising proportion has gone to finance leveraged buyouts. The first quarter of 2019 has seen a demand for wider spreads and stricter lending standards, which can be interpreted as a welcome dampening of exuberance or a worrisome sign of cyclical fatigue.
How serious is this situation? A longer-but-shallower downturn would imply a higher default rate than in previous cycles, and lower recovery levels from defaulting bank loans, and that makes a strong case for a quality-focused, fundamentals-driven approach to credit. But we believe the work-out of imbalances in the credit markets is likely to be a long, grinding process rather than the sort of sudden shock that could spark a substantial slowdown in the real economy.