Companies issuing lower rated debt may want to consider the risk of a “crexit,” in which credit providers in the newly shaped debt markets flee the riskier debt of companies that have added record levels of leverage to their balance sheets.
In a recent report titled “Financial Risk Is Rising For Some U.S. Corporate Borrowers As Debt And Leverage Reach Record Highs,” Standard & Poor’s notes that whether leverage is excessive tends to be best judged in retrospect. However, “what is clear is that median company debt levels are now in excess of those just before the financial crisis, boosted by the ample financing liquidity that has prevailed in recent years,” the report notes.
Some of that debt has been used for capital expenditures, but much of it has funded stock repurchases, dividends and high-priced acquisitions that may ultimately provide insufficient return on equity and hence lead to credit deterioration.
The mountain of debt companies have accrued becomes problematic as the economy slows, and S&P notes that it recently lowered its forecast for US economic growth while many economists foresee a global economic slowdown.
“Because companies’ ability to increase earnings generally correlates with GDP growth, this may constrain many borrowers’ ability to increase revenues at the same pace as they have taken on leverage,” the report says.
The issue is less relevant for investment-grade corporates, whose credit metrics have changed little over the last decade, the report notes, and in fact their interest coverage has improved as the companies have refinanced debt at historically low rates. The report adds, however, that the picture is less rosy for speculative-grade credits.
“Spec-grade rated companies, meanwhile, are clearly weighing down the rated universe as a whole, in terms of leverage metrics. This asset class has reached peak leverage ratios, and there’s been modest deterioration in interest coverage ratios,” the report says.
Although most corporate debt rated by S&P is investment-grade, speculative-grade debt issuance has “exploded” among companies that typically had been confined to bank financing. S&P says 90% of the new issuers it has rated over the last three years have been BB+ or lower. However, the rating agency says, when the credit cycle begins to decline, the optimal market conditions they typically require to issue bonds will likely fade.
Could that bring about a funding crunch? S&P notes that regulations have prompted banks, the traditional providers of bond-market liquidity, to withdraw from the market, and the nontraditional vendors filling the void, such as insurance companies and mutual funds, are more sensitive to market volatility. In light of these changes, corporate issuers have sought to extend their debt maturities out to 2010, limiting risk in the near term.
“Although many borrowers have been able to extend maturities, spec-grade issuers generally (and especially those rated ‘B-‘ and lower) have fewer funding options and higher funding costs, which makes them more susceptible to heightened refinancing risk,” S&P says. “Therefore, extended periods of volatility stemming from macroeconomic and sector-specific issues can quickly hamper capital market access.”