The Big Idea

The large and small stakes

Steven Abrahams | January 31, 2025

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.

Markets sometime seem like grade school playgrounds. The big guys have things going their way, and the small guys have to hustle to stay in the game. Well, these days that describes credit quality in corporate America. The balance sheets and credit of the big guys keep getting stronger, and the small guys, not so much. Investors get compensated for that, but whether it’s enough is a hard call. On the margin, go big.

Judging by leverage, cash on the balance sheet and operating margin, bigger companies continue to do better than smaller. Bigger companies have lower leverage, more cash and wider operating margins. That may be the way big companies get big or small companies get small in the first place, but the momentum has not faded.

The balance sheets of the S&P 500 and the Russell 2000 can roughly stand in for big and small companies. The market capitalization of the average S&P 500 company is currently $106.5 billion, while the average Russell 2000 is $1.6 billion.

Leverage of debt to earnings

Big companies have broadly reduced leverage over most horizons while small companies have headed in the other direction. The ratio of total debt-to-EBITDA shows the years it would take to pay off debt with current gross earnings. The average S&P 500 company could do that in 3.6 years, the average Russell 2000 in 5.8 (Exhibit 1). That number for the S&P 500 is down over the last one, five and 20 years. For the Russell 2000 it is up over the same horizons. Large companies have pushed up gross earnings faster than total debt, leaving them less vulnerable to financial conditions. Smaller companies grown debt faster than earnings and have become more exposed.

Exhibit 1: Leverage has gone down for big companies, up for small

Source: Bloomberg, Santander US Capital Markets

Cash on the balance sheet

Both large and small companies have added much more cash to the balance sheet, especially after the start of pandemic. Both the average S&P 500 company and the average Russell 2000 have added cash for most of the last 20 years with a surge in 2020 (Exhibit 2). Both now have relatively high cash balances whether looking back five or 20 years. But S&P 500 balance sheets currently have 68% more cash per share than Russell 2000, giving the larger players much more flexibility to adapt to changing circumstances. With the significant proposed changes coming out of the current administration in Washington, that flexibility could be more valuable than usual.

Exhibit 2: Large companies hold much more cash per share

Source: Bloomberg, Santander US Capital Markets

Differences in operating margin size and direction

Differences in operating margin between large and small cap companies is stark. That margin speaks to the cash flow from regular operations available to pay debt. The average S&P 500 company currently has a 13.9% margin, the average Russell 2000 a 3.7% (Exhibit 3). That mark for large companies is well above the prevailing levels of the last 20 years, at the 91st percentile, and moderately above the levels of the last five, at the 65th percentile. For small companies, the current margin is at the low end of the last 20 and last five years. And while margins for large companies have been steady or slightly higher in recent years, the margins for small companies have steadily declined.

Exhibit 3: Margins for Russell 2000 companies have declined in recent years

Source: Bloomberg, Santander US Capital Markets

Levels of compensation

Although the Bloomberg US Corporate Investment Grade Index does not overlap entirely with the S&P 500, it does broadly reflect the debt of larger companies. And although the Bloomberg US Corporate High Yield Index does not overlap entirely with the Russell 2000, it does broadly reflect the debt of smaller companies. Comparing those indices suggests the compensation for taking any kind of credit risk is very skinny. The option-adjusted spread on the investment grade index now sits at 79 bp, and on the high yield index at 262 bp (Exhibit 4). Comparing these indices is complicated by changes in the composition of both indices, with credit quality and rating improving in the last five years. Both are at the very tight end of their 5-year range and the 183 bp of spread between them correspondingly is at the tight end of its 5-year range.

Exhibit 4: Spreads on investment grade and high yield look skinny

Source: Bloomberg, Santander US Capital Markets

Even though spreads on the investment grade debt of larger companies look skinny, balance sheets look healthy and improving. Leverage is going down at larger companies, and margins are going up. For the debt of smaller companies, leverage is going up and margins down. Within an index allocation, whether investment grade or high yield, it looks like investors should migrate to the debt of larger companies. And across indices, pushing some allocation from high yield to investment grade looks like the right fundamental move.

* * *

The view in rates

The Fed dots and fed funds futures for the end of 2025 are within a few basis points of one another, so the Fed and the market see things the same way. Both expect roughly two cuts of 25 bp. But beyond 2025, the market is fading the dot path, with the market pricing funds 33 bp above the dots at the end of 2026 and 85 bp above the dots at the end of 2027. The futures market that far out is admittedly less liquid, but still. The market clearly does not believe inflation is dead. Breakeven 2-year inflation is now up 40 bp in January.

With longer rates, the appetite of foreign official portfolios and rising real rates seem to be playing leading roles. Foreign official holdings of Treasury debt in custody at the New York Fed fell through mid-January, in rough parallel with rising rates, and have since rebounded, in rough parallel with falling rates. Real 10-year rates similarly rose into mid-January and have since dropped back, again in line with the changes in nominal rates.

With discussions of tariffs, changes in immigration policy and an active battle underway in Congress over federal spending, the range of potential paths next year for the Fed has expanded. Rate volatility still does not look fully priced into options markets, especially for longer tenors.

Other key market levels:

Fed RRP balances jumped to $188 billion as of Friday, up $83 billion in the last week. Hard to anticipate that one. With RRP at 4.25%, Treasury repo and MBS repo both pay more, so cash has much better alternatives than RRP.30
Setting on 3-month term SOFR closed Friday at 429 bp, up 1 bp on the week.
Further out the curve, the 2-year note traded Friday at 4.20%, down 7 bp in the last week. The 10-year note traded at 4.54%, down 8 bp in the last week.
The Treasury yield curve traded Friday with 2s10s at 34 bp, flatter by 1 bp in the last week. The 5s30s traded Friday at 46 bp, steeper by 4 bp over the same period
Breakeven 10-year inflation traded Friday at 243 bp, up 1 bp in the last 1week. The 10-year real rate finished the week at 211 bp, down 10 bp in the last week.

The view in spreads

Implied rate volatility rose a bit in the last week. Volatility will likely depend on the tariff, immigration and fiscal policies implemented by the new administration. Those seem to be evolving quickly.

The Bloomberg US investment grade corporate bond index OAS traded on Friday at 79 bp, wider by 1 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 137 bp, wider by 1 bp in the last week. Par 30-year MBS TOAS closed Friday at 38 bp, wider by 1 bp in the last week.

The view in credit

Fundamentals for consumer and most corporate credit continue to look stable. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. Consumer debt service coverage is roughly at 2019 levels. The rate of serious delinquency in residential mortgages and of loans in foreclosure have barely changed over the last year. The balance sheets of smaller companies show signs of rising leverage and lower operating margins. Leveraged loans also are showing signs of stress, with the combination of payment defaults and liability management exercises, or LMEs, often pursued instead of bankruptcy, back to 2020 post-Covid peaks. If the Fed only eases slowly this year, fewer leveraged companies will be able to outrun interest rates, and signs of stress should increase. LMEs are very opaque transactions, so a material increase could make important parts of the leveraged loan market hard to evaluate.

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

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