How the pandemic may impact corporate creditworthiness in … · How the pandemic may impact...

The demand headwinds from the COVID-19 pandemic will undoubtedly lead to a technical recession, as the intentional shutdown of economies around the world will come with a clear contraction in global growth. Data from previous recessions indicate that markets react sharply to the prospects of a recession, a phenomenon which played out again in late March. It is our belief that as the credit cycle resets, attractive opportunities exist in corporate credit, as the asset class typically provides above average returns during this time.

Key Takeaways • Corporate Investment Grade Credit typically provides above average returns in periods

following sharp economic contractions

• The COVID-19 pandemic will weigh on corporate fundamentals over the short-term, but corporations are well positioned and have acted to offset weaker outlooks

• Downgrade risk may increase in 2020 but default risk should remain low and our internal credit research team will continue to play a vital role as we navigate through this period

Market Perspectives + 10 Minutes = Confident Investing

Robert Pemberton, Managing Director

Naoum Tabet,Vice President & Director

Eric Schure,Vice President & Director

How the pandemic may impact corporate creditworthiness in Canada


Source: Bloomberg Barclays Indices, Bloomberg, Moody’s, S&P, as of December 31, 2019.

Exhibit 1. Investment grade credit can offer greater return potential following a period of sharp economic contraction, but this comes with increased levels of credit risk.

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IG Credit CY Total Return (LHS) Canadian Real GDP (LHS) Global IG Defaults (RHS)

We also know that with this above average return potential comes higher levels of credit risk, as corporations face varying degrees of demand headwinds which can ultimately weigh on fundamental creditworthiness (Exhibit 1). For this reason, we look to identify the fundamental health of the corporate landscape in Canada, while also evaluating how corporations are reacting to the pandemic. This helps to ultimately draw conclusions on the relative level of risk corporations face as they move through this current pandemic.

Page 2 How the pandemic may impact corporate creditworthiness in Canada


In March of this year, credit markets experienced the most dramatic repricing since the Great Financial Crisis of 2008/09, as market participants started to gauge the impact of a downturn in economic activity and the effects it may have on corporations across Canada. As seen in the chart below, the March sell-off in Investment Grade Credit Spreads represented the second largest period of spread widening in recent history. In just 24 days, credit spreads increased by 250%, representing a much sharper sell-off than experienced in the Great Financial Crisis.

It is clear credit spreads have reacted sharply to the additional risk presented in the market. While this may be the case, we believe they have again overshot the actual inherent fundamental credit risk in the market. With the support of central banks and growing clarity on the economic outlook, the market has again grinded tighter, pushing valuations closer to projected fundamentals.

As we look to deploy additional capital into credit investments as the current cycle resets, we must do extensive work to avoid “potholes” along the way. These potholes represent the credits that face overwhelming demand destruction, which can ultimately lead to credit challenges including rating downgrades, late principal or interest payments, or in the most severe scenario, issuers defaulting on their debt obligations.

Exhibit 2. Massive and rapid spread widening during the pandemic.

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Source: Bloomberg Barclay’s Indices, as of June 9, 2020.

11/6/2007 to 1/2/2009

2/2/2020 to 3/24/2020

Experience


As you can see in the chart below, defaults have rarely occurred over the last several years, though when they do, they can have varying impacts on credit portfolios, mostly depending on the portfolio’s exposure to the issuer under pressure. The illustration also indicates that global default rates of investment grade credits jump as we enter and move through periods of economic contraction. With our belief that we should see higher levels of downgrades and defaults than we have in the past few years, we highlight that the work of our internal fundamental credit research team is essential as we move through this period of economic weakness.

Our fundamental credit research team’s rapid updates and adjustments to internal credit ratings allow us to steer clear of these potholes, while also getting ahead of anticipated downgrades which often come with significant adjustments to market pricing. The work of this team can also lead to broad conclusions about the market, quantifying the potential for higher levels of credit risk across the Canadian corporate market.

Source: Moody’s, S&P, as of December 31, 2018.

Exhibit 3. Historically, global default rates increase in periods of economic contraction.

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Global IG DefaultsGlobal HY Defaults



The Canadian corporate fundamental landscape As we look to gauge the impact on investment grade issuers in Canada from the COVID-19 related contraction in economic activity, we must first assess the fundamental health of the overall corporate market. This work includes quantifying the fundamental soundness on which corporations enter the crisis, the degree of pressure exhibited on businesses across varying sectors and investigating if corporate issuers are reacting prudently to the crisis.

Total debt levels in Canada, as seen in the chart below, have increased meaningfully over the last decade, as represented by the Canadian Aggregate Bond Index. Despite this dramatic jump, we believe the ability to service and repay this debt has remained fairly consistent over the last decade. In our analysis, we have found that many Canadian corporations, including both banks and non-financial debt issuing entities, are actually coming into the crisis with relatively sound balance sheets.

Exhibit 4. Total debt in Canada has increased by 107% since 2009.

Source: Bloomberg Barclay’s Indices, as of December 31, 2019.

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Exhibit 5. Corporations in Canada are entering the crisis on sound footing as represented by non financial and bank sector leverage.

Non-Financials Net Debt/EBITDA

Non-Financials 20 Yr Avg Banks 20 Yr Avg

Banks Tangible Equity / Tangible Assets

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Source: TDAM, Bloomberg Finance LP, ICE Bank of America Indices, As of December 31, 2019.

Digging a bit deeper, in the chart below, we use market leverage (Net Debt / EBITDA for non-financials, Total Common Equity / Total Assets for banks) as a proxy for the fundamental health of balance sheets across the Canadian market. To paint an accurate picture of how this leverage has changed over time, we compiled index constituents on the Canadian corporate index going back to 2000 and calculated historical leverage metrics on these entities.

Taking this one step further, we used a market weighted approach, meaning issuers with greater debt loads hold a greater weight in our calculated leverage statistics. As you can see, non-financial entities have entered the pandemic with roughly average levels of leverage, while the banking sector is coming in on very sound footing, a positive dynamic as we enter a period of short-term weakness.

Canadian Corporate Leverage

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The fundamental strength in which corporations are entering the 2020 crisis will allow them to combat short-term growth headwinds, which we estimate to vary across the many sectors in Canada. In the chart below we illustrate that sales and EBITDA estimates have been revised meaningfully lower for 2020, meaning that analysts are expecting top and bottom-line figures that are between 30% and 40% lower than originally forecasted at the beginning of the year.

Given the weaker backdrop anticipated, many companies have raced to shore up capital, first

cutting shareholder rewards (share repurchases and dividends) and capital expenditures. From the perspective of bondholders, this is a welcomed positive, as companies are clearly prioritizing balance sheet strength over shareholder payouts during this time. Disney for example, a single-A rated company that holds a track record of paying consistent dividends for 40+ years, already suspended their dividend as management prioritizes liquidity and creditworthiness over shareholder interests*.

Exhibit 6. Consensus estimates have been revised meaningfully lower since the beginning of 2020, as analysts cut expectations given the COVID-19 related demand destruction. Companies have reacted to the weaker growth outlook by racing to cut shareholder rewards and non-essential capital expenditures.

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2020 EBITDA Estimate Revisions 2020 Revenue Estimate Revisions

2020 Capex Estimate Revisions 2020 Dividend Estimate Revisions

Source: TDAM, Bloomberg Finance LP, as of May 15, 2020. *Source: Bloomberg Finance LP


Exhibit 7. The ability to raise new debt became extremely difficult as volatility peaked in March. With market functionality returning to pre-pandemic levels on the back of successful central bank intervention, corporate issuance has returned in record size.

In late March, as market liquidity seized up and economic pressures mounted, corporate issuers quickly drew down on their committed lines of capital (corporate revolver facilities) to bring liquidity onto their balance sheets and to combat the potential for mounting cash outflows. On the back of central bank intervention and a return to proper market functionality, primary markets around the world have since re-opened in a meaningful way. With the successful intervention by the Bank of Canada, initiating the Corporate Bond Purchase Program, issuers have been able to return to the primary market in Canada with record size.

As illustrated in the chart below, new issuance in Canada is up over 110% year to date, as companies are seizing the opportunity to raise funds to pay down their revolving credit facilities, refinance upcoming maturities, or simply build liquidity ahead of uncertain times. Now more than ever, a strong investment grade rating provides meaningful benefits as investment grade issuers have the clear ability to access the market and receive the lowest cost of funding.

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2020 Cummulative IG Issuance 2019 Cummulative IG Issuance

Source: Bloomberg Finance LP, as of May 1, 2020


We can draw some positive conclusions in the face of all of the clear negatives, as we believe companies will come out of the crisis prioritizing sound balance sheets more than ever. Currently, companies are clearly prioritizing and protecting their balance sheets over shareholder interests as well as M&A transactions. We believe this is so as the rationale for maintaining

an investment grade rating has arguably never been stronger and could lead to a fundamental shift in how companies think about how they capitalize their firms. Exogenous shocks like the COVID-19 pandemic proves the rationale for having access to additional balance sheet liquidity to manage through periods when cash flows can turn quickly negative.

Exhibit 8. Higher quality borrowers are rewarded with lower funding costs, a relative advantage which has increased since the beginning of 2020.

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BBB vs A HY vs BBB

Source: Bloomberg Barclay’s Indices, as of May 27, 2020.

Quality


Exhibit 9. During the market sell-off, shares of companies with stronger credit ratings experienced a less dramatic share price decline.

When our internal credit research team analyses a corporation, liquidity is a sub-component of our analysis that is scored independently of other factors. We believe as the economy rebounds, we could see issuers hold even more cash internally further bolstering their liquidity position. Maintaining a solid balance sheet, that will help ensure a company can successfully navigate through this period of weaker economic activity, will

demonstrate conservative financial management to both equity and credit investors. As illustrated in the chart below, the shares of higher quality investment grade companies actually outperformed as the market experienced its sharpest sell-off since 2008, indicating that equity investors may already be rewarding conservative management teams.

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TSX S&P 500

Source: Bloomberg Finance LP, as of March 31, 2020.

Average Share Price Change by Rating Bucket (2/19 to 3/20)



Downgrade risk has increased, but investment grade default risk should not reach 2009 peakWith our view that corporations are coming into the crisis on sound footing and in many cases have taken prudent steps to offset demand headwinds, we believe the prospects of downgrade risk have increased and are meaningfully higher than anticipated default risk. This is an important distinction, as downgrades come with the

potential for fairly sharp changes in marked to market values. However, defaults can come with significant real losses. As you can see in the chart below, S&P and Moody’s have acted swiftly to downgrade Canadian IG credits so far in 2020, reflecting the weaker outlooks for debt issuing entities across Canada.

Exhibit 10. Downgrades from public rating agencies have accelerated meaningfully in 2020.

Source: S&P, Moody’s, Bloomberg Finance LP, as of June 8, 2020.

Canadian IG Rating Actions: S&P & Moody’s

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ValueThe final thought We believe the significant back up in credit spreads can offer real fundamental value as the economic and credit cycle resets in 2020. It is our view that fundamentals will likely remain under pressure over the short-term, though we believe that Canadian corporations are well positioned and taking prudent actions to weather the current period of negative growth headwinds. While we have drawn conclusions

on the general market, we fully expect downgrade risk to remain elevated, and default risk may rise from the very low levels experienced over the last several years. For this reason, sound credit analysis and close collaboration with those pricing risk in the marketplace can allow TDAM to outperform, by steering clear of troubled credits and positioning our portfolios for the best potential outcomes for our clients.

The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment]. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank. ® The TD logo and other trademarks are the property of The Toronto-Dominion Bank or its subsidiaries.

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