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Leverage Is Making a Comeback in Corporate Credit

The Marriner S. Eccles Federal Reserve building in Washington, D.C., US.

The Marriner S. Eccles Federal Reserve building in Washington, D.C., US.

Photographer: Joshua Roberts/Bloomberg

Whisper it softly (or soft-ish), but leverage is making a comeback.

With the Federal Reserve raising benchmark interest rates at a faster pace than initially expected to tame inflation, the possibility of a ‘soft’ landing — one that would see prices cool while economic growth stays positive — seems to be fading. Meanwhile, higher rates are already sparking an increase in leverage, or overall indebtedness, for Corporate America — to say nothing of what would happen if they were combined with a slowdown in economic growth.

Median leverage for issuers of investment-grade corporate bonds already jumped 14% in the first quarter of 2022, when the Fed began raising rates, according to fresh figures from CreditSights Inc. That’s the biggest quarter-on-quarter move on record, the research shop says, and is “driven almost entirely by the drawdown in cash over the quarter as total debt also declined.”

It’s a tentative reversal of a post-pandemic trend that saw companies take advantage of ultra-low interest rates to term out their debt at much lower borrowing costs. With consumer spending proving unexpectedly robust, many companies also saw their cash balances increase in the years since the onset of Covid-19. The combination of more cash and cheaper borrowing costs, pushed net leverage to a record low across investment-grade and junk-rated companies in the third quarter of 2021, CreditSights says.

Now, the concern is that faster-than-expected rate hikes, elevated expenses and a slowdown in consumer spending could combine to reverse the trend. Net leverage already increased in the first quarter to 1.9 times earnings for investment-grade and 3.2 times earnings for junk-rated issuers with weaker balance sheets, according to CreditSights data. 

Heading into the second quarter earnings season “we expect investors to focus on margin compression amid inflationary pressures, the continued drawdown of cash balances and the outlook for fundamentals, including leverage trends,” wrote analysts led by Winnie Cisar, CreditSights’ global head of strategy. “With growth starting to shift and decelerate, we expect continued upward pressure on leverage, albeit not to crisis/stressed levels.”

They’re not the only ones concerned about the return of leverage after more than a decade of low interest rates. 

“Credit fundamentals are largely in good shape but [we] recognize that a much more aggressive Fed than previously expected has repriced valuation across markets and will weaken these strong fundamentals to some extent if they are successful at demand destruction,” JPMorgan Chase & Co. analysts wrote late last week.

Meanwhile Goldman Sachs Group Inc. cautioned that a “caustic combination of persistently high inflation and slower growth will further pressure margins.”

While balance sheets still look relatively strong, “the negative impact of cost inflation, slowing consumer demand and supply chain disruptions was visible in the first-quarter earnings season,” Goldman analysts let by Lotfi Karoui wrote on June 17. “Perhaps more importantly, the forward signal from management commentary suggested these headwinds are likely to linger (and in some cases, intensify).”