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Assessing corporate leverage trends

9. Mai 2019

Anando Maitra, CFA

Head of Systematic Research

Jamie Salt

Analyst

Global leverage¹ has increased substantially since the global financial crisis in 2008-2009. One focal point has been US corporate leverage, where a sharp rise in BBB-rated debt² has led to concerns that corporations may have taken undue advantage of low interest rates to leverage up to less sustainable debt levels. Since BBB-rated companies carry the lowest investment grade rating, the increased size of BBB rated corporate debt has led to concerns that there would be an influx of downgrades to below investment grade, or so-called fallen angels.

We have a different perspective on leverage and argue there are multiple ways to assess it besides the typical Debt-to-EBITDA³ measure. Alternative metrics – such as the ability to service debt - paint a less concerning picture, we believe. Taking into account alternative variables, leverage levels for listed companies are, in fact, below long-term averages⁴.

The proliferation of BBB-rated corporate debt issuers over the past decade is not due to an increase in leverage, we believe, but rather from effects set in motion by the 2008 financial crisis. For instance, regulatory changes led to companies increasing borrowing from the capital markets but decreasing borrowing through bank loans.

The increase in potential fallen angel borrowers from structural changes is indeed a concern for investment grade managers because they are forced to invest in investment grade only bonds. For universes with stable rating profiles, such as BBB to BB, however, such concern is diminished, in our view.

“We believe that historical fallen angels data is a poor predictor of the future quantity of fallen angels”

Ratings downgrade trends in the past are less suited to assessing today’s rating trends. The broad structure of the debt universe has changed over time, and the current mix of bond issuers is far more diverse than it was before the financial crisis. As such, we believe that historical fallen angels data is a poor predictor of the future quantity of fallen angels.

Ratings drift is a better variable to measure fallen angels supply, in our view. Ratings drift is predicted by changes in leverage rather than levels of leverage. Using changes in leverage, we find that expected downgrade rates are in line with historical averages and significantly below periods of credit market sell-offs⁵.

Overall, a more optimistic picture of corporate leverage emerges when it is assessed using broader metrics and set against a backdrop of changed debt issuance practices over the past decade.

Please find key terms in the glossary

sources.

¹ Leverage measures borrowing relative to income, company earnings or a country’s GDP. Private leverage measures debt relative to individual income. Company leverage typically measures the ratio of a corporate’s debt relative to earnings (such as EBITDA). Government leverage is usually measured by the ratio of government borrowing relative to GDP.

² Source: Factset, WorldScope, LOIM. US corporate debt-to-GDP from March 1988- March 2019. Past performance is not an indicator of future performance.

³ EBITDA refers to a company’s earnings before interest, tax, depreciation and amortization.

⁴ Refers to alternative leverage ratios of Debt-to-Enterprise Value and Interest-to-EBITDA from Dec 1989 to Jan 2019. Source Factset, WorldScope, LOIM. Past performance is not an indicator of future performance.

⁵ Based on a regression period of 1990-Jan 2018. Source: Factset, WorldScope, Bloomberg Barclays Indices, Moodys, LOIM calculations.

important information.

This document has been issued by Lombard Odier Funds (Europe) S.A. a Luxembourg based public limited company (SA), having its registered office at 291, route d’Arlon, L-1150 Luxembourg, authorized and regulated by the CSSF as a Management Company within the meaning of EU Directive 2009/65/EC, as amended.

Lombard Odier Investment Managers (“LOIM”) is a trade name.

This document is provided for informational purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This document does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipients exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. The contents of this document are intended for persons who are sophisticated investment professionals and who are either authorised or regulated to operate in the financial markets or persons who have been vetted by LOIM as having the expertise, experience and knowledge of the investment matters set out in this document and in respect of whom LOIM has received an assurance that they are capable of making their own investment decisions and understanding the risks involved in making investments of the type included in this document or other persons that LOIM has expressly confirmed as being appropriate recipients of this document. If you are not a person falling within the above categories you are kindly asked to either return this document to LOIM or to destroy it and are expressly warned that you must not rely upon its contents or have regard to any of the matters set out in this document in relation to investment matters and must not transmit this document to any other person. This document contains the opinions of LOIM, as at the date of issue. The information and analysis contained herein are based on sources believed to be reliable. However, LOIM does not guarantee the timeliness, accuracy, or completeness of the information contained in this document, nor does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice. Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term “United States Person” shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income. Source of the figures: Unless otherwise stated, figures are prepared by LOIM. Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.

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