Business cycles, interest rates, and credit conditions are intricately connected and influence corporate debt management. Corporates manage debt and liquidity across business cycles by adjusting debt refinancing needs, capital expenditure, and discretionary spending such as dividends, share buybacks, and M&As.
During economic expansion, companies have robust profitability and cash flows supported by healthy demand, making it relatively easy for the companies to service their debts. In this phase, corporates increase dividends, refinance existing debt or raise new debts at low rates, pursue M&As, undertake new investments, and even choose to deleverage voluntarily. Conversely, during economic downturns or recessions, companies experience lower revenues, decreased cash flows, and tight credit conditions, making it challenging to meet debt obligations. Accordingly, companies re-evaluate their debt management strategies to improve liquidity and financial strength.
Interest rates are an important tool that helps central banks navigate the economy through business cycles.
During COVID-19, central banks cut interest rates to support economic activities. This cheap pandemic-era funding was a liquidity bonanza for corporates as they were flushed with cash from bonds issued or refinanced at very low rates, which they deployed for shareholder remuneration and M&As. In general, corporates favor raising funding through bonds rather than equity issuance and bank loans as the cost of financing is cheaper. According to the US-based Securities Industry and Financial Markets Association (SIFMA), corporate bond issuance in the US, the largest fixed-income market in the world, rose to USD 2.3 trillion in 2020, up 64% from the previous year and was the highest in the past two decades. The increase in issuance volumes was seen across sectors and for both investment-grade and high-yield issuers. Issuance volumes stayed elevated at USD 2.0 trillion in 2021.
However, the funding spree slowed when the US Fed started raising rates in 2022 to combat the four-decade-high inflation of 9%. Consequently, US corporate issuance volumes dropped to USD 1.4 trillion in 2022 and 2023, back to 2019 levels. The global rating agency, Standard & Poor’s (S&P), stated that US bankruptcy filings rose to 642 in 2023, a record high since 2010, as companies struggled with high interest expense and wage growth. Most bankruptcies were concentrated in consumer discretionary, industrial, and financials sectors.
Apart from controlling discretionary costs and shareholder remuneration, corporates exercised the option to extend bond tenures to meet liquidity needs and manage debt. For instance, Aroundtown, a Europe-based real estate investment trust (REIT), and Deutsche PBB, a German bank, decided not to exercise the call option on their callable bonds as new issuance rates were significantly above the reset rates of the bonds. Furthermore, cautious investor sentiment largely deteriorated access to capital. Although these entities were able to maintain short-term liquidity, they attracted negative views from investors. The real estate sector was particularly hit by rising interest rates, given the indirect relation between real estate prices and interest rates. Hence, many REITs even repaid their debt from existing liquidity rather than refinancing or issuing new bonds at high rates.
Due to tight monetary policy globally, the total value of M&A activity dropped 15% to USD 1.2 trillion in 2023 and the number of transactions fell 24%, as per S&P. Moreover, M&A deals were smaller compared to 2022 and corporates resorted to raising equity or share swaps to keep the leverage ratio (Net debt/Earnings before depreciation, interest, and taxes) in check.
Senior Analyst
Investment Research and Advisory
Aranca.
An interesting case in the current rate-tightening cycle is the oil & gas sector. As oil prices plummeted to low levels during the pandemic, oil & gas companies considerably raised debt to support operations. However, as oil prices recovered, they started deleveraging, with long-term debt-to-equity ratio falling to <40% in 2023 from 60% in 2020. Companies are now opting for leverage-neutral stock deals for M&As rather than debt issuance.
By the end of 2023, the US 10-year treasury yield dropped from a peak of 4.99% in October to 3.86% in December, amid increased speculations for interest rate cuts and growing prospects of a soft landing. This allowed companies to take advantage of the relatively low borrowing costs as the drop in treasury yield tightened credit spreads. According to SIFMA, corporate bond issuance rose 29% and 33% year-over-year in January and February 2024, respectively.
Overall, corporations managed their debt liabilities well in the current credit tightening cycle, underpinned by sound fundamentals and appropriate leverage strategies, especially investment-grade issuers. We expect debt management pressure to ease as central banks worldwide start cutting interest rates in the second half of 2024.
