Over the last several years, there has been a rather large shift in the amount of gross leverage corporate credits have been willing to endure. Today’s chart shows over 50% of investment-grade corporate debt in the JPMorgan non-financial universe had gross leverage under two times EBITDA* at the end of 2012. By the end of 2016, this fell substantially to 20% of the universe. At the other end of the spectrum, this period saw debt levered over four times EBITDA go from 11% to 25%.
The prolonged low global interest rate environment and challenging growth backdrop has spurred debt-financed mergers and acquisitions and shareholder-friendly activities, leading to this shift in leverage. Also contributing to the swing has been the material decline in oil and other commodity prices, which has caused EBITDA to decline and leverage to rise in the energy and metal & mining sectors.
Despite the rise, average quality has only declined by one notch to the A3/Baa1 range as rated by Moody’s in the Barclays Corporate Credit Index as the increase on a net basis has been more modest. The rating agencies have been somewhat accommodative to meaningful gross leverage increases as long as the credits demonstrate a well-defined path to pay down debt over a reasonable time period. The credit markets have also taken a relatively patient view of the rise in gross leverage. The index option adjusted spread has tightened over the last four years from 141 basis points (bps) to 123 bps. However, spreads are off the tights of 97 bps experienced in 2014 when crude was near $90/barrel and the interest rate environment was essentially the same as it exists today.
Key Takeaway:The gross leverage picture has shifted notably higher for investment grade non-financial debt over the past several years during a time when spreads have also tightened. Although net leverage has not experienced a shift of this magnitude, corporate credit spreads leave little room for companies to misfire on their deleveraging plans and creates a challenging market environment for corporate credit investors.
*Earnings before Interest, Taxes, Depreciation and Amortization
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