Borrowing costs

U.S. businesses are less able to service their debt even with record borrowing costs

Record borrowing costs were not enough to prevent a decline in the ability of U.S. companies to service their debts in the first half of 2020.

The median interest coverage ratio of US companies classified as investment grade by S&P Global Ratings fell to 5.48 in the second quarter, from 5.65 in the first quarter and 6.32 at the end of 2019. For non-investment companies grade, the ratio – calculated by dividing earnings before interest and taxes, or EBIT, by the cost of its interest payments on debt – was 2.6 in the second quarter, compared to 2.4 in the first quarter, but down from 2.8 in the fourth quarter of 2019.

Falling ratios reflect slump in earnings as the coronavirus pandemic ravaged the U.S. economy: Average earnings per share across the S&P 500 fell 33.3% year-over-year in the second trimester. The relatively small drop in interest coverage ratios is due to the fact that the Federal Reserve lowered its key rate from 1.5% -1.75% to 0.0% -0.25% in March.

This helped push the average cost of borrowing for quality U.S. businesses to an all-time high in June after peaking at the start of the pandemic. The yield to maturity of the S&P 500 Investment Grade Corporate Bond Index, which stood at 2.10% in early March, rose to 4.20% later in the month. It has since fallen to 1.74% in August and was at 1.95% on October 5.

“In [the first half of] 2020, these interest coverage ratios have declined even though the Fed [funds rate] was going close to zero, “Evan Gunter, director of S&P Global Ratings, said in an interview.” What we’re mainly looking for is a rebound in economic growth and a recovery in revenues. “

Some sectors have been hit harder than others. Premium consumer discretionary companies were among the best positioned sectors before the pandemic with an interest coverage ratio of 11.2 in the fourth quarter of 2019. Successive declines of 25% in the first quarter and 34% in the second quarter resulted in the ratio halved to 5.6.

The consumer discretionary sector, which includes hotels, retailers and restaurants, has been particularly affected by the pandemic. The industry leads the number of bankruptcies among large U.S. corporations this year. Of the 509 bankruptcies S&P Global Market Intelligence tracked through October 4, 102, or 20%, were from the consumer discretionary sector.

The energy sector also performed poorly by this measure. Its interest coverage ratio, at 4.58 among investment grade companies, was already among the lowest as the pandemic approached. By the end of the second quarter, it had fallen to 2.42, meaning that almost half of its companies’ profits were spent on debt service.

Energy companies accounted for 11.6% of US bankruptcies tracked by S&P Global Market Intelligence this year, third after industrials.

Sectors with stable or improving interest coverage ratios this year include health care, which fell from 8.44 to 9.84, consumer staples, which rose from 7.89 to 8.50, and information technology, which slipped from 11.76 to 10.01.

The sector with the lowest interest coverage ratio in the second quarter was real estate at 1.96, but this is only slightly below its historical average of just over 2. Real estate is a business. leveraged, but revenue streams are generally stable as landlords work with 5, 7 and 10 year lease structures, helping them get through the economic disruption. Utilities have an equally low ratio, 2.49 for the investment grade and 1.81 for the non-investment grade, but like real estate, they have a reliable revenue stream, with bills usually being the last expense to pay. be reduced by households.

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Financials have the highest ratio, at 10.42, little different from its historical average.

Lower interest coverage ratios contributed to lower creditworthiness, a particular concern for companies rated just above the investment grade.

There have been 41 fallen angels in the world companies that have been demoted from investment grade to non-investment grade so far in 2020 with 19 of them in the United States, while S&P Global Ratings has downgraded only 22 companies in total in 2019. S&P noted in a recent report that the 2020 final total is on track to break the 2009 record of 57 fallen angels worldwide.

The downgrades in the United States mean that a total of $ 252 billion in rated debt has fallen into the high yield bond segment.

However, the worst may have already passed for companies on the eve of a so-called junk rating.

There was only one addition to Fallen Angels in August, the lowest since April, while five companies were removed from the potential Fallen Angels list between July and August.

Among companies S&P has listed as potential fallen angels, the proportion considered to be at immediate risk of downgrading fell to 11% in August from 13% in July, and is significantly lower than the five-year high of 27% in April. .

“The Fed’s policies have certainly helped ensure that there is sufficient liquidity to keep investors from being overly concerned about the balance sheets of viable long-term companies,” said by email Anik Sen, global head of equities at PineBridge Investments.

“Investors are still concerned about the balance sheets of leveraged companies that are heavily affected by the pandemic, especially those that had weak business models before the pandemic. Bankruptcies and credit downgrades always happen for these types of businesses ”, Sen wrote.