May 21 - Which benchmark for credit risk?

May 21 - Which benchmark for credit risk?

Published: May 21, 2021

There’s been an interesting topic some days ago on FT : “Is leverage still the best benchmark of credit risk?”.  The question was about the Corporate Debt market (HY and Leverage Loans), where the average leverage ratios has been raising  as a backdrop of the Covid-19 Pandemic. As of today average market lev ratios are about 5.4x and 4.8x for the Total and Senior leverage respectively. They were at 5.2x and 4.5x as of 2019 in the pre-pandemic world.

Generally, market participants seem not worried about it: “ It’s true that Debt to Ebitda ratio has been increasing over the 2020 year due to the steep drop in revenues and profits. But it’s also true that available free cash-flow (“Afcf”) has not changed as much. And this because the very low interest rates and accommodating fiscal policies make the Corporates’ debt burden sustainable”. In a few words, their statement is “Corporates might have more debt on their shoulders but they also have more free cash-flow to serve the debt”.

Other market players are a little more sceptical about this statement as they note that historically leverage ratios have always been a sign of concern about potential incoming financial crises. For these guys, arguing the value of the leverage ratios as credit risk indicator, is a tricky way to convince themselves they are not invested in risky assets.

Who is right?

Probably none of them. I’m firmly convinced that credit risk could not be captured by one indicator, nor by leverage ratios and neither by Afcf or interest coverage ratios. Assessing the credit risk of a Corporate it’s not a matter of quantitative valuations only. Qualitative considerations matter even more. Loans and High Yield bonds are long-term asset (seven year maturity). So the Corporate’s debt sustainability has to be assess on a matrix basis, where industries trends, competitive landscape, technology issues and so on, cross macro events as changes in the monetary and fiscal policies that could affect credit risk appreciation and refinancing availability from market players.

In a nut shell: there are not short-cut to assess credit risk. Sooner or later, skipping the hard work of a thoroughly fundamental analysis would only lead lazy investors to a painful experience.