Are Corporate Bond Yields Accurately Reflecting the Rise in Corporate Leverage

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Market Performance

Corporate bond yields in the US remain near or close to historical lows (or at least since the 1950s), with the average yield on AAA rated debt trading at roughly 4%. Although we focus on US corporate yields and data in this article, the same trend is reflected across all major developed economies. Even in many emerging-market economies, despite the correction in late 2015 / early 2016, general corporate yields still remain well below the levels that prevailed prior to the Global Financial Crisis (GFC) in 2008.

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*The above data is based on corporate bonds rated by Moody’s only

The current low level for corporate bond yields are in the main due to the fact that sovereign or risk-free bond yields are also still trading near historical lows. This is particularly relevant in Europe and Japan. In Europe in particular, corporate bond yields have also been suppressed by the European Central Bank’s (ECB) ongoing ‘QE’ programme, with a portion of the ECB’s monthly purchases also being directed towards the corporate bond market.

Although the Federal Reserve in the US is now raising interest rates, US corporate bond yields have also continued to benefit from this supportive tailwind emanating from across the Atlantic. The cyclical recovery in Europe now appears sufficiently sustainable so the ECB will likely soon begin to ‘taper’ it’s massive QE programme. As financial markets adjust to the new regime, reduced demand from the ECB is likely to start pushing yields higher on both sovereign and corporate debt over the next 12 months.

Apart from low sovereign yields, compressed spreads between corporate bond yields and sovereign yields have also been a key factor. Although corporate spreads have been lower in the past, the current spread is still near or at a cyclical low for the cycle that began after the GFC in 2008.

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Several years of accommodative monetary policy and low wage inflation since the GFC have helped boost corporate profitability and keep corporate leverage ratios contained at levels comfortable to bond investors. At a consolidated level, some US corporates have also built up large cash balances, which has provided further comfort to investors, or at least superficially.

The chart below from Factset Research shows how cash levels have grown robustly since 2008 and that cash as a % of debt remains well above the levels seen in 2008.

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Low bond yields have also led to large issuance by the corporate sector in recent years. Some the increase in leverage has been directed at share buybacks, which is an exercise primarily aimed at boosting earnings per share growth.

As such and despite the growth in their cash balances, leverage has now risen to the highest levels since 2007. Looking at the most commonly used metric, net debt to Ebitda, this ratio has risen from between 1x and 1.5x to around 2.2x at present. This is still relatively low in a historical context, but at approximately 2.5x, this ratio is now higher than was the case in 2007 if one excludes financials and technology.

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As most consolidated corporate cash balances in the US are accounted for by the major technology companies, with Apple alone having a total cash balance around $250bn, it is useful to exclude the technology sector.

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As already previously noted, corporate profit margins are furthermore still at or near the upper-end of their historical range. This obviously creates upside risk to corporate leverage ratios going forward, in the event that corporate profit margins come under pressure. As formerly detailed, we believe there is an increasing risk of profit margins being eroded over the next few years due to rising labour costs and potentially higher raw materials.

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In recent research, Barclays detail how a 5% decline in Ebitda would take the leverage ratio of the SP500 ex-financials to around 2.8x if one assumes zero growth in payouts or dividends. This level would be close to the record highs for corporate leverage evident back in 2000, ahead of the technology and telecom bust.

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In summary, it appears that current corporate bond spreads are too low, particularly for lower-rated or BBB corporate debt. Not only are corporate yields at risk from a potential rise in sovereign bond yields, but they are also now at risk of a re-pricing based on the relative increase in corporate leverage evident over the past five years.

Based on the 2000 to 2003 experience, BBB corporate bond spreads are probably between 50bps to 150bps too narrow. If we assume that sovereign bond yields in the major developed economies are on average 100bps below ‘fair value’, then the upside risk to corporate bond yields from current levels can easily be estimated at between 150bps and 250bps.

Looking at corporate emerging market bond spreads, much the same argument can be made. A re-pricing in developed market corporate debt will also inevitably impact on pricing for corporate debt in emerging markets, including that in South Africa.

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