March 26, 2021 | Vanguard Perspective
Global investors were already nervous about BBB-rated corporate bonds before COVID-19 joined the world's lexicon. Significant growth in debt on the bottom rung of the investment-grade ladder, coupled with rising corporate leverage, left investors fearful that a recession could trigger a wave of downgrades to high yield, which would result in market dislocation.
Downgrades of BBB-rated companies to high-yield status (fallen angels) did pick up amid the sudden and deep recession brought on by the pandemic. But investors' worst fears didn't materialize, thanks in part to swift monetary and fiscal responses along with corporate proactivity.
"We are now entering the recovery phase of the credit cycle, and corporate fundamentals will begin to improve," said Maria Colangelo, Vanguard senior credit analyst and co-head of the global industrials team. "We now expect to see an increase in rising stars—companies moving out of high yield and into investment grade—and believe fallen angel migrations will be muted."
With interest rates near historic lows, corporations have had an economic incentive to increase their leverage and take on higher levels of debt. This has been driven in part by investor demand for additional yield, which has enabled companies to finance at low rates.
Corporations taking on more debt has resulted in rapid growth in the U.S. investment-grade credit market. BBB debt grew notably during the decade ended December 31, 2020, leaving that segment as the largest of the investment-grade index, according to Bloomberg Barclays. The bulk of BBB debt is from companies in the United States—the U.S. investment grade market represents nearly two-thirds of the global market.
"A lot of the pre-COVID angst in the credit market was owing to the run-up in BBBs," Ms. Colangelo said. "Investors were concerned about the risk of downgrades to high yield, which is highly correlated with economic cycles."
An often-used gauge of companies’ gross leverage is the debt/EBITDA ratio—the amount of earnings available before taking into account interest, taxes, depreciation, and amortization expenses.
At the peak of the COVID-19-induced economic downturn, global corporate leverage hit multiyear highs as earnings slumped. Debt of companies rated A and above had risen to about 2.2 times EBITDA and those rated BBB hit about 3.5 times. The most leveraged companies in the BBB segment were at about 4.0 times EBITDA.
However, declines in leverage since then, especially as the earnings recovery has surprised to the upside, suggest the risk of a wave of fallen angels will lessen and the number of rising stars may increase.
Interest coverage, another important metric of companies' ability to pay the interest on their outstanding debt, did not weaken as much as the leverage ratios, likely because of the impact of low interest rates.
Corporate managements proactively raised capital during the peak of last year's crisis, and the increased corporate cash balances buffered elevated debt levels. "In periods of financial stress, such as during the 2008 global financial crisis, companies tend to enter self-preservation mode, where they build up their cash balances to position themselves for uncertainty and to increase liquidity," noted Ms. Colangelo. "This phenomenon occurred in the wake of the COVID outbreak, with cash held by U.S. corporations increasing nearly $400 billion compared with 2019."
The liquidity cushion built up by corporations through significant capital raising in 2020 has enabled rating agencies to be patient with companies, giving them time to manage down their high debt loads. At the same time, governments and central banks globally provided sufficient fiscal and monetary support to ensure that the worst of the economic downturn, while severe, was short-lived.
It's worth drawing credit distinctions between BBB issuers in more and less economically sensitive (cyclical and noncyclical) businesses. Non-cyclicals such as consumer staples and utilities make up the larger slice of the overall BBB bond index, and the growth of their overall debt outstanding has outpaced that of cyclicals including airlines, hotels, and retail. Cyclicals are more volatile over time, and their profits are typically harder hit in recessions. Within this group, low-BBBs in the issuers more sensitive to the pandemic were at the highest risk, and this was reflected in their valuations.
Corporate leverage and cash balances have been improving—declining and rising, respectively—in Europe as well, but trailing behind the U.S., and the market has already factored in a lot of the recovery.
A boost to market sentiment from the rollout of vaccines has been partly offset by the reintroduction of lockdowns in parts of Europe. And while we believe that monetary and fiscal stimulus will continue to contain the yield premiums that corporate bonds must offer above government securities to attract investors, it will also continue to hurt banks' profitability.
Corporations directly affected by persistent lockdowns, such as traditional retail companies, may not fully recover for some time, leading to potential earnings disappointments in 2021. "Despite the extraordinary government and regulatory measures being taken, uncertainty remains about the impact of extended lockdowns, the risk of a further wave of COVID-19, and the outside chance of potent new variants," said Samuel Lopez Briceno, a Vanguard senior European credit analyst.
"All in all, our focus will continue to be on security selection and bottom-up analysis," Mr. Lopez Briceno said. "Our experienced global research team of 30-plus credit analysts proactively seeks to identify idiosyncratic credit drivers that we believe provide diversified sources of alpha."
Vanguard believes that COVID infection rates are paramount to how quickly the global economy recovers. "A full recovery in both the economy and the corporate credit market will hinge on vaccination success and economic normalization," said Ms. Colangelo. "While spreads are historically tight, we believe select idiosyncratic opportunities still offer attractive risk-reward."
Market expectations over the next 12 to 24 months are for debt ratios of corporations rated A and above to fall from about 2.2 times EBITDA to about 1.5 times, and for debt ratios of corporations rated BBB to decline even more sharply, from about 3.5 times EBITDA to about 2.5 times. These estimates are based on EBITDA growth; any debt pay-down through free cash flow would result in further credit improvement.
Vanguard has positioned its active funds throughout the pandemic to benefit from slow but progressive improvements in BBB-rated issuers' leverage ratios, said Arvind Narayanan, a Vanguard senior portfolio manager and head of investment-grade credit. "The worst in terms of credit deterioration is behind us," Mr. Narayanan said. "However, as interest rates rise, investors need to be cognizant of the risks in longer-duration bonds. We remain neutral on credit valuations and will be looking to pick our spots."
Senior credit analysts Maria Colangelo, based in the United States, and Samuel Lopez Briceno, based in the United Kingdom, provide fundamental research coverage of investment-grade debt issuers for Vanguard's Active Taxable Fixed Income Group. Arvind Narayanan is a senior portfolio manager within that group.
The team manages $275 billion globally in fixed income assets (as of February 28, 2021), expressed in U.S. dollars.