INSIGHTS

On August 22, 2022

AAM Viewpoints — Is Corporate Credit Strength at the Precipice of Collapse?

Economic headwinds in the U.S. are blowing hard this year, steadily increasing the risk of a recession (if we are not already in one). This naturally raises concerns about credit quality.

For now, credit quality is proving resilient, whether looking at ratings actions, the net ratings bias, or defaults, which remain low. But signs of degradation in credit quality are rising. For example, the U.S. distress ratio (the proportion of speculative-grade (rated 'BB+' or lower) issues with option-adjusted composite spreads of more than 1,000 bps (basis points) relative to U.S. Treasuries) reached 9.2% at the start of July, the highest level since October 2020, as investors price in their concerns about persistently high inflation and a potential slowdown in the U.S. economy. As a reference, the five-year average distress ratio is 7.3% and was 4.3% in the beginning of June. As the cost of funding rises across the board and GDP growth falters, the question that looms is, “When will the pressures become too much for corporate borrowers?”

Roughly, movements in the distress ratio run parallel to movements in the U.S. default rate with several months lead time.

Meanwhile, the pace of rating upgrades still exceeds downgrades, albeit by a narrowing margin.

Source: Moody’s | EMEA = Europe, the Middle East, and Africa; APAC = Asia-Pacific

That said, the substantial refinancing and build-up of cash encouraged by pandemic stimulus measures means that many sectors are well-placed to deal with a relatively short, mild recession. Cyclically sensitive industries would still see pressure on credit metrics, but they start from a better place than is typical for a recession. A more severe recession would be far more challenging across the board, but particularly for sectors not yet fully recovered from the impact of the pandemic such as hotels, gaming, leisure, or real estate.

As corporations accelerated their borrowing, especially in 2021, bond proceeds were used to push back debt maturities, thus enhancing liquidity.

Said another way, the high yield maturity wall is very light in the next two years, with only $129 billion, or 10% of the high yield market, scheduled to mature through 2024 lessening the probability of defaults..

Meanwhile, S&P is reporting that the corporate default tally through July 2022 of 43 is well below previous year-to-date tallies of 54 (2021) and 72 (2020) with no signs yet of picking up.

While corporate defaults are expected to modestly rise, according to the rating agencies, as borrowing costs rise, the prospect of a protracted military conflict between Russia and Ukraine, materially slower growth of the world economy, elevated prices for energy and commodities, longer-lasting supply-chain disruptions, and increased financial market volatility take their toll, default rates a year from now are expected to remain below the long-term trend, according to Moody’s and S&P, due to the aforementioned relatively modest refinancing needs over the next 12 months as many companies recently refinanced. According to Moody’s, the current global trailing 12-month global speculative-grade default rate is at 2.1% as of the end of June 2022. Moody’s expects it to climb to 3.7% in June 2023, still below the long-term average of 4.1%.

Supporting the premise of resilient corporate credit quality in the face of growing recessionary pressures, is the near-record high level of total corporate cash and cash flows.

Release:Quarterly Financial Report  
Units:  Millions of Dollars, Not Seasonally Adjusted
Frequency:  Quarterly
Further information related to the Quarterly Financial Report survey can be found at https://www.census.gov/econ/qfr/about.html
Methodology details can be found at https://www.census.gov/econ/qfr/documents/QFR_Methodology.pdf

This is not to minimize the growing credit pressures on corporate credit, but to emphasize that, in general, corporations are in much better condition to deal with these pressures than in recent history, while some sectors should fare better than others.

An additional growing credit pressure to watch is the weakening of the consumer balance sheet. The Federal Reserve reported that aggregate household debt balances increased by $312 billion in the second quarter of 2022, a 2.0% rise from the first quarter of 2022. Balances now stand at $16.15 trillion and have increased by $2 trillion since the end of 2019, just before the pandemic recession. While delinquencies have grown modestly, it is still well below the long-term average and, according to quarterly reports from airlines, cruise lines, and hotels, has not yet negatively impacted consumer spending in these areas, but has shifted discretionary spending priorities for retailers.

But, as S&P notes, supply-chain constraints and rising labor costs have squeezed companies in the consumer products sector driving many negative rating actions over the past year. Some companies have navigated the pressures by raising prices and cutting costs, but incremental risk is growing because of rising interest rates and the softening macroeconomic backdrop. This will especially hit, per S&P, B and B- rated companies in the sector as these are already highly leveraged with moderate to minimal free operating cash flows (FOCF). Per S&P, the consumer products and capital goods sectors have the highest numbers of 'B-' rated issuers with negative outlooks or on reviews for additional downgrades.

Air traffic is booming, with the airline industry enjoying full planes and high fares. In North America, there is continued surprising rate strength in hotels, theme parks, and Las Vegas gaming — even cruise ship pricing has strengthened for 2023 bookings. But profit margins are starting to come under pressure. Surging costs are the nearest thing to a universal theme across the sector, encompassing material, energy, logistics, and labor costs. In some cases, the increases have been extreme. But it is rare to find a sector that hasn’t been able to manage these cost pressures by passing them on or by enjoying higher volumes. This speaks to the breadth of inflationary pressures, but also suggests that a more budget-conscious environment will threaten a rapid adjustment to profitability. In some cases, while higher costs have constrained profitability, improvement is still evident — higher fuel prices have reduced the benefits to airlines from surging passenger numbers but have not stopped the swing back to profit. Nonetheless, there is little optimism that this benign margin environment can be sustained given slumping consumer confidence, still escalating business costs, and the prospect of faltering growth.

Also noted is that supply-chain disruption remains widespread, with both shortages and bottlenecks still widely reported, and exacerbated in some cases by labor shortages. S&P believes that the second half of the year should start to bring improvement in some areas such as semiconductor manufacturing capacity, meaningful output increases and containership capacity, while being currently tight, but with a ramp-up of vessel deliveries that should start to have an impact next year. The China COVID lockdowns remain a wildcard.

In conclusion, while credit pressures build, credit quality will likely weaken, but this weakness comes at a time of near unprecedented corporate strength. Therefore, we believe corporate credit strength is not near a collapse.

For the weakest borrowers, however, the first half of the year has seen debt issuance slump and brought a rapid repricing of credit risk. The impact has been lessened by the favorable credit conditions preceding this, but, according to S&P, lower-rated, speculative-grade issuers remain more at risk from a recession, particularly if it appears that stagflation is taking hold, bringing stagnant growth and persistent inflation. Highly leveraged issuers are often relying on stronger EBITDA (earnings before interest, taxes, depreciation, and amortization) growth in the next 18–24 months to support refinancing as opposed to a no-longer-accommodative capital market, per S&P. This could be problematic in the face of weakened credit conditions.

CRN: 2022-0804-10233 R