Viewpoints
Taking a closer look at corporate credit metrics

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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      By John H. Croft, CFAInvestment Grade Fixed Income Portfolio Manager/Senior Credit Strategist, Eaton Vance Management

      Boston - Corporate credit markets have enjoyed a strong run so far this year, with healthy investment grade (IG) and high yield (HY) bond returns thanks to the move in U.S. Treasury rates, coupled with the relative attractiveness of the U.S. dollar credit markets as global rates have fallen to new lows.

      At the same time, businesses have taken advantage of the lower rate environment and growing demand to issue bonds. Over the past few years, corporate profits have been rising, but at a slowing pace, with forecasts suggesting earnings growth around 0% for 2020. How have all these moving parts affected corporate credit metrics?

      We've heard a lot of talk about the deterioration in corporate credit, which would have broad implications for the next downturn if global growth continues to wane. So we looked across a wide swath of the credit universe to gauge the average company's leverage ratio and ability to service its debt load.

      Broadly speaking, what we found is that corporate credit health has only modestly deteriorated as leverage has increased and debt servicing capability has decreased. This slip in the health of corporates has come at a time when spreads relative to Treasuries are narrowing to all-time tights.

      Leverage rising as debt levels growing faster than earnings

      Since 2014, the experience for both IG and HY corporates has been similar: Both universes have been growing debt levels faster than earnings, thus increasing leverage as measured by the ratio of earnings before interest, taxes and depreciation allowances (EBITDA) to total debt.

      Even though our analysis confirmed that EBITDA has been rising for the past several years — with the HY universe showing a much larger percentage increase since the low in 2015 — leverage has been increasing as well. Several research reports have pointed out the rise in total corporate debt outstanding, but we would argue that the more important measure is the relative impact versus rising earnings.

      For IG corporates, the increase in the leverage ratio has been more modest, up approximately 0.25 times to 2.54 times. The rise in leverage within the HY corporate market was a little more pronounced, where the companies we studied saw their leverage increase by 0.4 times to 4.6 times. Yet the trend in leverage is clearly rising for IG issuers, while it's more muted for the HY cohort. With added leverage in the IG space and much more downside than upside, we would emphasize the need for active security selection in that market.

      Leverage uptrend more muted in HY than IGHistorical_leverage_IGHistorical_leverage_HY

      Source: Bloomberg annual data from 2014 to 2018. IG = ICE BofAML U.S. Corporate Index, HY = ICE BofAML U.S. High Yield Index. Data provided for informational use only. Past performance is not a reliable indicator of future results.

      Growth in debt more than offsetting declines in rates

      Low rates have benefited consumers and corporates alike, as they decrease the cost of debt. For corporate bond issuers, though, the growth in debt has more than offset the decline in rates, which has put downward pressure on interest coverage as measured by the ratio of earnings before interest and taxes to interest expense. Over the past five years, IG and HY corporates saw their interest coverage ratios deteriorate by 0.3 times and 0.4 times, respectively. Again, that's not a drastic move, but it's in the wrong direction with the possibility of a worsening economic environment looming on the horizon.

      Interest coverage declined despite lower ratesHistorical_intcoverage_IGHistorical_intcoverage_HY

      Source: Bloomberg annual data from 2014 to 2018. IG = ICE BofAML U.S. Corporate Index, HY = ICE BofAML U.S. High Yield Index. Data provided for informational use only. Past performance is not a reliable indicator of future results.

      Bottom line: With the combination of lower spreads and higher leverage in the corporate sector, we believe the security selection and fundamental analysis of active management has become even more important for investors in fixed income credit.