The Big Idea

Spreads outrun fundamentals in corporate credit

Steven Abrahams | February 11, 2024

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. This material does not constitute research.

Spreads on corporate credit have tightened faster than most risk assets since the Fed pivoted in November and markets reached for the champagne. Average spreads on investment grade and high yield now stand at the tight end of their 5-year range. Not all credits are equal, of course, The balance sheets of larger issuers look stronger than the balance sheets of smaller issuers. But neither in aggregate look strong enough to warrant current levels of spreads. Corporate valuations look fundamentally rich, although rich things can get richer.

On a few basic measures of balance sheet health—leverage, cash balances and profitability—larger companies look stronger than smaller companies but not as strong as implied by current spreads. One way to see that is to look at these measures for S&P 500 companies, which includes US companies with an average market capitalization of $87.2 billion, and on Russell 2000 companies, which includes US companies with an average market capitalization of $1.4 billion. Goliath, meet David.

Bigger balance sheets show better, lower leverage

On debt-to-earnings leverage ratios, measuring the years of trailing 12-month earnings needed to repay outstanding debt, the big names win. The average S&P 500 company could repay all debt in 3.69 years while the average Russell 2000 company would take 6.46 years (Exhibit 1). That leaves the average S&P 500 name at the 8th percentile of the 20-year distribution for this measure. That is, the average S&P 500 company today can repay faster than all but 8% of the time in the last 20 years. The average S&P name is at the 25th percentile of the 5-year distribution, able to repay faster than all but 25% of the time in the last five years. The average Russell 2000 name, by contrast, is at the 78th percentile of the 20-year distribution and the 51st percentile of the 5-year distribution. On this measure of leverage, the average big issuer warrants current tight spreads while the average small issuer does not.

Exhibit 1: Debt-to-earnings is down for large companies, flat-to-up for small

Note: percentiles show the last value as a percentile of either its 20Y or 5Y range, where 100% means the highest level, 50% means the median level and 0% means the lowest.
Source: Bloomberg, Santander US Capital Markets

On net-debt-to-earnings ratios, looking at years to repay debt after subtracting cash currently on the balance sheet, the gap between large and small names gets bigger. The average S&P 500 company can repay net debt with 1.39 years of trailing earnings while the average Russell 2000 company needs 4.53 years (Exhibit 2). This measure also is toward the tight end of the 20-year range for the S&P 500 companies and the wide end for the Russell 2000. Over the last five years, net-debt-to-earnings ratios for both large and small companies are only slightly below their medians.

Exhibit 2: Net-debt-to-earnings also looks better for larger names

Bigger balances sheet show more cash, but all companies have added cash

On available cash and other liquid assets, larger companies again look stronger than smaller companies. But companies of all size have more liquidity than usual. The average S&P 500 company has $629 in cash and short-term investments per share while the average Russell 2000 company has $325 (Exhibit 3). Both amounts are high relative to balances over the last 20 years and moderately above the median relative to balances over the last five years. The higher liquidity serves as a buffer against a temporary drop in revenue or other economic shocks.

Exhibit 3: Both large and small companies have relatively high liquidity

Bigger companies have higher profit margins

Finally, bigger companies post higher profit margins, making debt service easier. The average S&P 500 company shows a current operating profit margin of 13.49%, toward the high end of its 20-year distribution and slightly above the median of the last five years (Exhibit 4). The average Russell 2000 company shows 5.00% operating margin, roughly in the bottom third of its distribution over 20 years and right at the median of the last five.

Exhibit 4: Bigger companies show better operating profit margins

The recent credit record

Because of stronger balance sheets, bigger companies tend to get more investment grade ratings while smaller companies tend to get more speculative grade. The recent credit picture for investment grade companies looks strong, according to S&P, with upgrades roughly balancing downgrades in the last quarter of 2023. For speculative grade companies, however, defaults—counting both payment defaults and distressed exchanges—have been rising as the Fed has pushed up interest expenses and slowed revenue growth (Exhibit 5).

Exhibit 5: Default rates have been rising among speculative grade companies

Note: Defaults include payment defaults and distressed exchanges.
Source: S&P, Santander US Capital Markets

Moderately rich valuations for larger issuers, rich for smaller issuers

Spreads on both investment grade and speculative grade corporate debt lately have traded around the 20th percentile of their range over the last five years, tighter, in other words, than 80% of the time in the last five years. That seems like thin risk premiums in light of current fundamentals. On net-debt-to-EBITDA, on cash and short-term investments per share and on operating margin, the fundamentals for both large and small companies range around the median of the last five years. On total-debt-to-EBITDA, large companies do show values around the 25th percentile of the last five years with small companies at the 51st percentile. Only on large companies’ total-debt-to-EBITDA does the fundamental seem consistent with current spreads. That leaves current valuations looking fundamentally rich.

Rich assets clearly can get richer, and corporate credit has performed well in the last year despite showing spreads richer than MBS and structured credit. Credit has benefited from steady demand from insurers in the US and worldwide. And that demand is likely to continue. But spreads already look like they have more than fully priced corporate fundamentals, while other sectors, such as consumer credit, look wide relative to fundamentals. At the very least, lagging fundamentals and better relative value in some other sectors should limited the potential for even tighter spreads in corporate credit.

* * *

The view in rates

The market continues to pull back from its earlier aggressive view of Fed cuts this year. The market priced for 125 bp of cuts before the January 31 FOMC but closed Friday at 100 bp. The market-implied chance of a cut in March stood just below 50% before the FOMC but closed Friday at 19%. The FOMC jawboning worked to rationalize the market a bit, with the curve flattening and risk spreads widening. Implied rate volatility remains elevated on news of bank commercial real estate troubles. And Treasury liquidity remains relatively poor.

Other key market levels:

Fed RRP balances closed Friday at $569 billion, up $56 billion week-over-week but part of a steady trend down since April. Treasury bills and Treasury and MBS repo all trade at yields above the RRP’s 5.30% rate, giving money market funds good reason to move cash out of the RRP and into these higher-yielding alternatives.
Setting on 3-month term SOFR traded Friday at 531 bp, up 2 bp week-over-week although broadly lower since September.
Further out the curve, the 2-year note closed Friday near 4.48%, 13 bp higher on the week. The 10-year note closed at 4.17%, higher by 4 bp on the week.
The Treasury yield curve closed Friday afternoon with 2s10s at -31, steeper by 4 bp In the last week. The 5s30s closed Friday at 24 bp, unchanged over the same period.
Breakeven 10-year inflation traded Friday at 225 bp, higher by 4 bp over the last week. The 10-year real rate finished the week at 192 bp, higher by 11 bp in the last week.

The view in spreads

The January FOMC, reports of bank losses from commercial real estate and strong January payrolls have interrupted the regularly scheduled tightening of risk spreads. Liquidity is likely to trend lower through 2024 as QT and relatively high rates in the front end of the curve continue. Lower liquidity is likely to keep volatility elevated, keeping pressure on spreads, leaving them a tad wider than otherwise. Nevertheless, spreads should trade stable to tighter until at least March.

The Bloomberg US investment grade corporate bond index OAS closed lately at 95 bp, tighter by 1 bp over the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 149 bp, tighter by 1 bp in the last week. Par 30-year MBS TOAS closed Friday at 45 bp, roughly 2 bp wider over the last week. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so a widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer sheets look relatively well protected against higher interest rates, and eventual Fed easing should relieve pressure from interest rate expense and falling liquidity. Fixed-rate funding has large blunted the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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