Investment grade-rated US companies are likely to deleverage in response to higher-for-longer interest rates, suggesting a sustained period of restrained bond issuance.

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Leverage has already fallen by some metrics. The median debt-to-equity ratio, a closely watched measurement of corporate leverage determined by calculating total liabilities as a percentage of shareholder equity, of investment-grade companies fell to 93.9% in the fourth quarter of 2022. That is down from a peak of 107% in the second quarter of 2020 when companies ramped up debt levels in response to ultra-low interest rates at the start of the COVID-19 pandemic.

Rising interest rates have pushed up the cost of debt, making financing for activities like mergers, research and development and share buybacks more expensive. The measures to reduce exposure to higher borrowing costs may start a process of improving credit ratings after years of binging on cheap debt to fuel record levels of M&A at the expense of credit quality.

"For a generation we had generally declining interest rates, and because the cost of debt was getting cheaper and cheaper there was more leveragability on balance sheets, so this is a change," said Gregg Lemos-Stein, head of analytics and research at S&P Global Ratings. "We now have a shift in the other direction; naturally it's going to mean" deleveraging.

Debt buildup

Up until very recently, companies have preferred to maintain low-cost, long-term debt and put cash to work rather than use it to pay down debt. Bond issuance volume ratcheted up to a record level of $1.203 trillion in 2020 as companies funded M&A, capital investment and share buybacks. That figure was cut by more than half to $532.48 billion for full year 2022 as interest rates rose.

Debt among nonfinancial corporations has risen to around $20 trillion, up from a pre-pandemic level of $17.8 trillion and nearly double what it was a decade ago. Meanwhile, credit quality has dropped. There has been a particular buildup in the BBB tranche where some $3.6 trillion of debt is rated just one notch above "junk" or "high yield" ratings at which point the investor pool is much smaller but yields are substantially higher.

SVB Financial Group and First Republic Bank are among six companies that have lost investment grade status and now have to refinance their debt at high-yield prices. There are another nine potential "fallen angels" out there with a combined debt of more than $80 billion. Aerospace giant The Boeing Co. is the largest of that bunch, holding $55.8 billion of debt.

"The cost between each grade is even higher now in this environment," Lemos-Stein said. "The BBB crowd wants to be a bit more solid and have more of a buffer to ensure they won't face a downgrade."

Lemos-Stein expects there to be a concerted effort for these companies to raise their credit ratings to BBB+ to reduce borrowing costs, though they likely will not try to reach the A range.

For now, the market is not punishing downgrades to non-investment grade. The spread between the S&P Global investment-grade corporate bond BBB index and the BB index was just 109 basis points on June 9, down from 195 basis points in June 2022.

"Attaining higher ratings will not necessarily be a motivating factor for companies to deleverage," said Timothy Crawmer, director and head of global credit at asset manager Payden & Rygel. "Companies will simply be driven to deleverage their balance sheets because the all-in cost of debt is much more expensive now."

The prospect of sustained higher rates, as inflation proves to be stickier than hoped for, has changed the environment for taking on debt. Companies will likely reduce leverage through less debt-financed spending for growth rather than pay down existing debt, according to Steven Oh, global head of credit and fixed income, co-head of leveraged finance at PineBridge Investments.

"We expect the majority of companies to refrain from deleveraging through debt payments and prefer to deleverage via EBITDA growth initiatives," Oh said.

Higher rates eat into M&A returns

Heftier borrowing costs seem likely to keep a lid on M&A activity.

"The impact is not purely due to the isolated factor of higher rates but expectations that the higher rates will additionally negatively impact the macroeconomic growth outlook," Oh said. "Companies prefer to increase their liquidity cushions when entering a period of greater economic uncertainty."

Cheap financing in the wake of the Great Recession contributed to a boom in M&A activity that peaked with $2.459 trillion of deals agreed to in the US and Canada in 2021 as the economy rebounded from pandemic lows. That buying frenzy slowed to a crawl in 2022 as aggregate deal values fell to $1.477 trillion.

A slump in the cost of takeout targets could change things, but equity prices are rising with the S&P 500 up nearly 12% this year.

"Equity valuations are not attractive currently," said Crawmer.