Capital Markets

Debt-to-Equity Ratio Down 34 Percentage Points from Pandemic High

Debt-to-equity and interest coverage metrics for high-yield companies belie the trouble brewing in credit markets.
Debt-to-Equity Ratio Down 34 Percentage Points from Pandemic High
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Despite weak second-quarter earnings and two-and-a-half years of negative operating cash flow, executives at Norwegian Cruise Lines forecast tailwinds for 2023. An uplift in cruise bookings next year and higher prices will “rebuild and improve margins” and maximize cash flow generation, the company told analysts on its October 6 investor day.

To help improve its balance sheet, Norwegian, like other highly leveraged companies, plans to pay down some of its $12.2 billion in long-term debt. In the next two to three years about $1 billion per will mature.

But the company’s board is eschewing “issuing any sort of equity to pay down debt or to delever,” Norwegian CFO Mark Kempa told Yahoo Finance Live on October 6. 

Instead, the debt will be paid off “in the normal course of business by just good old-fashioned earnings and cash generation,” Kempa said. 

A wider look at data from S&P Global Market Intelligence on about 8,000 U.S companies rated by S&P Global suggests many already shed cash reserves to pay down debt in the second quarter, lowering debt-to-equity ratios below pre-pandemic levels.

The median debt-to-equity ratio — calculated as total liabilities as a percentage of shareholder equity — for the investment grade issuers fell to 88.6% in the second quarter and has been falling since the opening quarter of 2020. Debt-to-equity for non-investment-grade companies fell to 123.4% (see chart).

Companies “piled on debt to bolster cash reserves” during the worst of COVID-19 and are now reducing their stockpiles, according to S&P analysts. The second-quarter movement in corporate cash ratios — calculated by dividing holdings of cash and equivalents by current liabilities — backs up that conclusion.

“[Issuers] would prefer “to pay down debt rather than refinance at higher borrowing costs,” according to the S&P report.

Indeed, with widening spreads and returns in the -18% range year to date for some bond investors, only $295 billion of corporate debt was issued in the third quarter, according to SIFMA, down 33% from 2021. 

Debt Payment Coverage

But lower debt-to-equity ratios are not the whole story.

The interest coverage ratio for the S&P-rated companies — a measure of the ability of the issuer to cover interest payments with earnings — was also healthier than pre-pandemic levels.

Strong earnings have lifted interest coverage ratios, said S&P. “But with persistent inflation forcing the Fed to raise rates further, the outlook for earnings is weaker.”

In other words, the upward move in interest coverage the past two quarters and the fall in debt-to-equity ratios may be short-lived.

Bank of America is forecasting S&P 500 earnings will rise just 2% year over year in the third quarter. And in Robert Phipps’ September 27 capital outlook, the director of Per Stirling Capital Management said expectations for 2023 corporate earnings “are still far too optimistic at 8%, whereas we actually expect flat to negative earnings next year.”

If that happens, paying back debt is likely to be way down the stack of a CFO’s priorities for uses of cash. Unless, of course, a company is in desperate need of maintaining a credit rating or violating a loan covenant.

Overall, the data and analysis coming out of credit markets point not to balance sheet health but to a future of distress for highly leveraged businesses.

In its Global Financial Stability Report issued on October 11, the International Monetary Fund indicated credit metrics in the U.S. leveraged loan market, in particular, suggest a coming wave of defaults.

More than half of the market for leveraged finance is now composed of firms with a “B” credit rating (generally, two or three notches into speculative-grade territory), according to the IMF. In part due to competition from the private credit market, the fund’s report indicated, one-third of newer leveraged loans have ratios of debt to EBITDA greater than six times earnings (4x to 5x is red flag territory).

“The credit quality of some of these assets,” according to the IMF, “may be tested during a recession.”