Record Cash Via Bond Issuance Is Both A Blessing And A Temptation

Record U.S. corporate bond issuances this year--$1.6 trillion among investment-grade companies and $400 billion for speculative-grade firms through November--have largely eliminated near-term liquidity concerns for all but the lowest-rated issuers. What began as a rush by highly rated companies to lock in a degree of insurance in March and April eventually made its way down the spectrum to 'BBB' and 'BB' rated issuers. Many not only pushed out upcoming maturities in 2020 and 2021, but also added liquidity for general corporate purposes.

The U.S. Federal Reserve's plan to keep benchmark interest rates near zero for at least three more years also bodes well for future liquidity needs if the pandemic and recession worsen or vaccines become delayed. As it stands, cash and investments held by the U.S. nonfinancial/nonutility corporate issuers we rate rose 30% to a record $2.5 trillion in the first half, while debt rose 9% to $7.8 trillion (Chart 1).

Chart 1

Table 1

Debt is rising amid weaker earnings for most issuers, as is leverage for both investment- and speculative-grade companies during the first half (which suggests high corporate cash may not last long). Debt issued for refinancing almost doubled to more than $600 billion through the third quarter, and so has debt raised for general corporate purposes, to more than $700 billion from $361 billion a year earlier, according to Leveraged Commentary & Data.

To be sure, we believe the near-term uncertain economic outlook likely will keep corporate issuers' balance sheets relatively conservative. However, if the economic outlook brightens in 2021 as coronavirus vaccines become widely available, we believe some issuers will revert to more aggressive financial policies. While some, such as AT&T Inc. and BP PLC, issued and then redeemed debt upon realizing it was no longer needed, we believe more may opt to return cash to shareholders with what may be viewed as excess liquidity, especially given the record low cost of funding. Highly rated investment-grade issuers, especially in the technology sector, used more equity than before as part of acquisition consideration. However, we believe issuers may more aggressively use excess cash or raise new debt if overall economic conditions improve (Chart 2).

We expect U.S. corporate debt issuance to decline meaningfully next year, as much of the prefundings already took place for upcoming maturities. Aggregate cash balances will likely also increase in 2021, as they have done historically for issuers we rate. But we believe corporate net debt will widen from $5.3 trillion as of the first half of 2020 as issuers deploy some cash set aside for a rainy day. Cash balances and liquidity at large have been resilient through the COVID-19 pandemic, but credit profiles may tell a different story.

Chart 2

After the Tax Cuts and Jobs Act (TCJA), a trend emerged in January 2018 in which cash as a percentage of assets and of debt began to decline. This coincided with increased share buybacks and, to a lesser extent, rising dividend payments. But this reversed in the 12-month period ending June 2020, with those percentages rising. Debt increased $610 billion and cash balances rose $570 billion. We view this indicates companies were shoring up liquidity reserves. As pandemic-related shelter-in-place restrictions began in the first half, the accompanying economic toll was--and, in fact, still is--unclear. Fearing capital markets might become unavailable as the pandemic persists, issuers that were beginning to suffer business disruption, along with those yet to feel any effects, proactively tapped the market. This came in varying forms, with revolving credit facilities being accessed, as well as incremental term loans and bond issuances (Chart 3 and Table 2).

Chart 3

Debt Rises As Companies Proactively Bolster Liquidity

Our sources and uses analysis supports our view that issuers chose to preserve liquidity (Chart 4). Coinciding with tax reform (effective Jan. 1, 2018), "deficits" began to arise in the June 2018 last-12-months period, primarily as companies distributed repatriated cash to shareholders. This has turned positive on a June 2020 last-12-months basis. We expect this "surplus" to build up for the full year and persist into 2021.

Chart 4

Table 2

Reacting to office closures, companies with the capability moved their workforces to remote environments. Our conversations with issuers suggest many expected to cut capital expenditures (capex) this year as real estate projects are paused. Twitter Inc., Facebook Inc., Microsoft Corp., and Slack Technologies Inc. are among the more high-profile companies that have already indicated a major shift in their approach to office staffing. With the expectation that management teams will reevaluate their office footprints, we believe this may lead to lower capex in 2021, which should help preserve liquidity.

The economic disruption from the pandemic isn't uniformly distributed. It can even vary within sectors viewed as at risk (e.g., retail), with some businesses deemed essential. While most will suffer to varying degrees, a small subset may thrive, leading companies to rethink their shareholder return strategies. In general, we see a pullback in share buybacks, with issuers such as Intel Corp. and McDonald's Corp. pausing these programs. Ford Motor Co. and Walt Disney Co. are examples of high-profile issuers that suspended dividends. We believe these are prudent measures to preserve liquidity given the unprecedented devastation of the COVID-19 pandemic.

Now that the U.S. is almost nine months into the pandemic, we expect issuers in stronger positions to resume shareholder returns, reinstating dividends or resuming share buybacks.

Sector Liquidity And Leverage Profiles

Table 3

Table 4

Table 5

Cash Flows Are Flat, Cash Balances Are Increasing

Chart 5

Table 6

Capex may decline as liquidity pressures mount

Capital spending generally mirrors overall economic activity--increasing in good times, declining in bad. From 2011-2015, during the recovery from the Great Recession, capex as a percentage of cash flows averaged around 55%. However, beginning in 2016, a trend emerged in which this metric fell to an average of 47% from 2016-2019. Additionally, this has dropped for the June 2020 last-12-months period to 44%, and will likely fall further as issuers look to preserve liquidity, pause discretionary capex, and evaluate their future capex needs related to real estate (Chart 5). We expect capex as a percentage of cash flows to remain depressed in 2021 as management teams are hesitant to commit to large projects pending better economic clarity.

Dividends face pressures, but are relatively stable on an absolute basis

Dividend payments as a percentage of operating cash flow have been mostly flat since the Great Recession. The TCJA, the 2019 trade dispute with China, and coronavirus pandemic appear to have little effect on this component of capital allocation. From January 2011 to December 2019, dividends averaged about 27% of operating cash flow; it was only down slightly in the June 2020 last-12-months period. The relative steadiness of these payouts should come as no surprise, given the permanence that dividends tend to have on capital allocation policies.

Share repurchases, up significantly since tax reform, have declined during the pandemic

Share repurchases, on the other hand, were rising since TCJA was enacted. We view buybacks as a more discretionary component of capital allocation. In this regard, management teams can be more opportunistic in determining the timing and size of these shareholder returns versus the rigid nature of quarterly dividends.

Having averaged about 29% of operating cash flow from 2011-2015, share repurchases are not a new phenomenon, with funding in certain instances facilitated by accessing offshore cash via synthetic repatriation (in which companies hold cash abroad to avoid taxes and tap domestic debt markets). However, a slowdown in 2016 was noticeable as the tax-reform debate took shape. As issuers began to speculate using offshore cash instead of debt to fund these programs, buybacks bottomed out at 24% by the December 2017 last-12-months period. With TCJA in place, corporations unwound their balance sheets and returned cash to shareholders, with buybacks as a percentage of operating cash flow rising to 35% for 2018. For the June 2020 last-12-months period, as cash preservation took priority, this fell to 26%. Similar to capex, we expect this to decline further for the full year and remain low in 2021. However, with certain companies disrupted less than expected during the pandemic, depressed stock prices in some sectors could allow management teams to become opportunistic.

Top 1% Cash Holdings Shrink Comparatively

The total cash positions of the top 1% of companies improved by more than $80 billion, to $1.06 trillion, in the first half. But their cash-to-debt ratio continued to decline, to 89% from the peak of 137% in 2016. This is the lowest ratio since 2007, just prior to the Great Recession, and tells the story of U.S.'s leading corporations' buildup of cash through the recession and the dramatic increase in overseas cash holdings by leading technology and health care companies, followed by the unwinding of balance sheets after tax reform. As a result, the top 1%'s cash now makes up 42% of the total corporate cash, a significant decline from a peak of 52% in 2017 (Chart 6).

Chart 6

In contrast, the top 1%'s debt increased significantly in the first half of this year, rising more than $200 billion to nearly $1.2 trillion as the Federal Reserve's low rate policy encouraged already cash rich companies to refinance and issue long-dated notes for general corporate purposes. This tops the peak of $1.1 trillion in 2017 before the repatriation of overseas earnings.

Over the longer term, we expect the cash positions of the top 1% to continue to weaken comparatively. High ratings on these companies (mostly above 'A') reflect strong liquidity positions that have served them well through the COVID-19 pandemic. But we believe some of the largest cash rich companies are on a gradual journey to slowly unwind their balance sheets and take on leverage profiles more in line with our ratings. Apple Inc., for example, intends to become roughly net-cash-neutral. But given its massive cash flow generation, it will take another few years of significant shareholder returns to reduce its cash position. As mega-cap technology companies mature and industry volatility abates, we believe they will take on balance sheets and leverage profiles that mirror other corporations.

'BBB' Rated Debt Increases As Credit Metrics Deteriorate

The aggregate amount of 'BBB' rated debt increased 9% ($200 billion) to $2.53 trillion in first half of 2020 from the second half of 2019 (Table 7). However, cash balances also rose $190 billion over the same period, allowing S&P Global Ratings-adjusted debt to remain flat. Despite this, deteriorating EBITDA caused S&P Global Ratings-adjusted leverage to rise to 3.3x for the first half of 2020 from 3x for the second half of 2019. This continues a trend in the 'BBB' category and marks the first time leverage has risen above 3x (Chart 7). We note the rise in leverage is slightly different this time, with deteriorating EBITDA the main contributor. Historically the culprits were rising debt, declining cash balances, and increased shareholder returns.

Chart 7

Table 7

Although leverage in 2019 rose only slightly from the high-2x area seen throughout 2015-2018, this is considerably higher than the 2.1x in 2010. While companies were more prudent with debt issuance after the Great Recession, data suggests 'BBB' rated companies over the years have taken a more aggressive approach to leverage. However, if the U.S. economic recovery stalls, we believe companies will pull back on authorized share repurchases, either preserving balance sheet cash or repaying debt to maintain investment-grade ratings.

Table 8

Additional Credit Rating Deterioration Is Still Unclear As A Second COVID-19 Wave Emerges

S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that a number of experimental vaccines are highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

The impact of COVID-19 this year undoubtedly carries negative credit implications, with aggregate EBITDA and cash flow from operations deteriorating in most sectors. Reactions to the situation were swift, with shutdowns across the world contributing to our expected 2020 GDP declines of about 3.9% in the U.S. and 4% globally. We expect GDP to increase about 4.2% in the U.S. and 5% globally in 2021, predicated on a vaccine becoming available. Credit markets continue to function well for now, with access to liquidity serving as a lifeline and enabling many issuers to maintain operations, albeit reduced in many instances. For this subset of issuers, while leverage will likely rise into 2021, we view default risk as lower than for those without access, though negative rating actions (downgrades, negative outlooks) could continue.

For lower-rated issuers with limited access to additional liquidity, already enacted conservative approaches to capital investments and shareholder returns are likely to persist into 2021. This prudent balance sheet management is paramount for many to offset the negative credit implications from a declining EBITDA base and reduced cash flow. With COVID-19 case counts rising in many cities in the U.S. and abroad, a renewed lockdown will only lengthen the recovery with some issuers already surviving on borrowed time, simply unable to withstand any further economic strain to their businesses.