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Spread compensation per turn of leverage in IG corporates

| September 20, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Much has been made over the past several years about the increasing leverage on corporate balance sheets, due in large part  to the accommodative rate environment. The past several months has seen this trend continue, as the flattening of the long-end of the yield curve in the four months that preceded September fueled a fresh round of opportunistic debt issuance from investment grade corporates.

Management teams have become more aggressive, terming out their maturity schedules further, and targeting additional higher coupon debt for early redemption to help pare down interest expenses. As a result of these actions, the amount of aggregate debt in 10+ year debt increased drastically to 34.4% from 28.5% over the past 5 years. Similarly, the amount of 3- to 5-year debt on corporate balance sheets decreased from 20.7% to 16.5%.

Investment grade universe tilts towards lower-rated credit

Also well documented has been the increase of lower-rated credit—specifically BBB credit—as a portion of the overall IG universe. Five years ago, BBB debt made up 42% of the IG Index, versus 45% for single-A and 11% for AA; and just 1% remaining in AAA with few issuers still seeing the top rating category as beneficial. The relative amount of BBB debt has risen ~17% to 49% of the entire IG Index, while single-A has declined to 41% and double-A to 8%. Even within the broader rating categories, issuers have moved further out the credit spectrum, as BBB- has increased to roughly 12% from 9% just 5 years ago and mid-BBB has risen to 19.5% from 16%.

Exhibit 1: Historical spread of BBB versus A- and AA-rated corporate debt

Note: The Bloomberg Barclays Corp IG Index is used as a proxy for aggregate corporate debt. Source: Bloomberg, Amherst Pierpont Securities

Investors have gotten more comfortable taking on additional credit risk, and therefore higher overall leverage in their IG investments (Exhibit 1). It’s possible to gauge how much investors are being compensated for leverage across the credit curve by evaluating the spread per turn of leverage.

First, leverage is assessed for each investment grade sector, across 5-, 10- and 30-year duration buckets (Exhibit 2). It is not surprising that the utilities sector, which includes electric and natural gas issuers, carries substantially more leverage than the rest of the IG Index, given the regulated and therefore highly consistent nature of cash flows relative to the rest of the non-financial Index.

Exhibit 2: Average gross and net leverage by sector, across the curve

Note: For the purposes of the sample, all members of the IG Index in each respective sector and bucket are used, excluding private companies without readily available financial data, or companies that do not report traditional EBITDA figures. The debt issues are otherwise exhaustive for each category. Financials were excluded as leverage is not calculated on a debt-to-cash flow basis for all industries; and perhaps more importantly, the biggest issuers (notably money center banks) have largely moved in the opposite direction over the past decade, raising capital and reducing systemic leverage. Calculations are made using Total and Net Debt to EBITDA, weighted by individual issuer par amount outstanding. Leverage calculated with no additional adjustments made for leases, pensions or other non-debt components of leverage. Excludes autos and other issuers with large finance operations, but utilizes an estimated leverage figure for GE. Likewise, index-eligible secured debt, such as EETC pass-thrus, are excluded. Source: Bloomberg Barclays US Corp Index, Bloomberg Company Financials, Amherst Pierpont Securities

Spread per turn of leverage varies by sector and across the curve (Exhibit 3). Once again, it should be expected that the mostly regulated utilities sector is going to compensate investors less per turn of debt leverage relative to the rest of the IG Index. Also note that each duration bucket will contain a different cohort of issuers, which can have considerable influence over the aggregate debt compensation. Typically the higher risk issuers will be more limited in their ability to issue longer-term debt without exhibiting a substantially steeper spread curve.

Exhibit 3: Spread compensation per turn of leverage

Note: Calculations are made using weighted aggregate bond G-spreads versus the Total and Net Debt-to-EBITDA. Leverage calculated with no additional adjustments made for leases, pensions or other non-debt components of leverage. Excludes autos and other issuers with large finance operations, but utilizes an estimated leverage figure for GE. Likewise, index-eligible secured debt, such as EETC pass-thrus, are excluded. Source: Bloomberg Barclays US Corp Index, Bloomberg Company Financials, Amherst Pierpont Securities

Obviously, leverage is only one factor in determining valuation. The use of exclusively Index eligible bonds in specific on-the-run duration buckets helps limit the liquidity and dollar price influences on bond valuation. And while leverage is just one piece of the puzzle, it is a big one and serves as a good starting point and accurate proxy in guiding investors as to how much risk compensation is available for each additional turn.

Exhibit 4: Top 5 issues – spread-to-net leverage

Note: Leverage calculated with no additional adjustments made for leases, pensions or other non-debt components of leverage. Excludes autos and other issuers with large finance operations, but utilizes an estimated leverage figure for GE. Likewise index-eligible secured debt, such as EETC pass-thrus, is excluded. Source: Bloomberg Barclays US Corp Index, Bloomberg Company Financials, Amherst Pierpont Securities.

Exhibit 5: Top 5 issues – spread to gross leverage

Note: Gross figures utilized for these sectors due to frequency of low/negative net leverage. Extremely limited 10-year rail issuance.  Leverage calculated with no additional adjustments made for leases, pensions or other non-debt components of leverage. Excludes autos and other issuers with large finance operations, but utilizes an estimated leverage figure for GE. Likewise index-eligible secured debt, such as EETC pass-thrus, is excluded. Source: Bloomberg Barclays US Corp Index, Bloomberg Company Financials, Amherst Pierpont Securities.

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