Assessing corporate leverage trends

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Assessing corporate leverage trends

Anando Maitra, CFA - Head of Systematic Research

Anando Maitra, CFA

Head of Systematic Research
Jamie Salt - Analyst

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.

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