Uncategorized

Spread compensation per turn of leverage in IG corporates

admin | 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.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.