What does a “New Normal” mean? Liquidity through the lockdown has been forefront of everyone’s minds. Now looking further out what does a 10%,20%,30% or even 50% reduction in revenues mean?

We think it means more defaults,more downgrades, more waivers, more secured lending, more loan to bond transactions, more extend and pretend. Over the next 12-24 months, anything but a “V” shaped recovery will see credit metrics worsen exponentially.

Operating leverage has been and will continue to be front and centre when it comes to credit analysis over the next year. For those who don’t know what this is check out this explanation on investopedia. The Degree of Operating Leverage is the % change in Earnings (EBIT) for a given % change in Revenues. The higher this is the more fixed costs there are in the business, which require a minimum revenue to offset,

In good times Operating leverage is your friend, once fixed costs are covered left over revenue falls through to profit. In bad times fixed costs mean that any decline in revenues results in a large decline in earnings. More than that, companies with large fixed cost bases will experience significantly higher earnings volatility. Volatility = Uncertainty, Uncertainty = Risk.

When you bring operating leverage and combine it with financial leverage you have a potent combination. Financial leverage amplifies the benefits and risks of operating leverage.

Until recently increasing leverage has been a risk investors have been willing to take. Share buybacks have been returning “value” to shareholders, funded by debt. New high Yield deals have had weaker covenants, higher leverage and tighter spreads and in a low yield world have been lapped up as “cheap”.

Now, thinking 1 step ahead, i.e post lock down, high yield debt investors are faced with companies that could face long term declines in their revenues. 2 steps ahead and that means issuers cutting more costs and a likely decline in asset bases. 3 Steps ahead that means likely lower asset values as companies reduce their cost base or mothball plants, higher unemployment and increased competition. 4 steps ahead and I think you get to your “New Normal”.

To go from Step 1 to Step 4, and the pace at which it happens, will depend on the extent of additional government support, central bank liquidity and how fast the economy opens up. Solvency will be tested/ stressed and as a result there is going to be a lot more negative rating action and engagement of companies with their lenders.

Now, if we look at what happens to leverage as you reduce your earnings (EBITDA), the reduction in the denominator results in a larger increase in the ratio. So -when you are thinking about covenants – the ratios and the distance current leverage is from them – is not linear. That headroom you thought you had is that little bit closer than you would like.

What is more – where companies start from is equally important. High starting leverage means no where to hide in the face of meaningful Earnings declines. Essentially, a 30% decline in EBITDA translates into a 42% increase in leverage. A 50% decline results in a 100% increase or doubling of leverage.

Here, we aren’t thinking about the degree of operating leverage, e.g. “What was the decline in revenues that resulted in an EBITDA decline of X%?”.

When we start to look at the impact of variable and fixed costs the higher the proportion of fixed costs or lower proportion of variable costs the steeper the blow out in leverage.

Investors’ margin for error is greatly decreased when high operating leverage meets financial leverage. Further, moderately levered companies are likely to see their risk profiles worsen more than expected.

 

In Chart 2 model a simple issuer with a 50% EBITDA margin and starting leverage of 2x. We then look at what happens with for a given revenue decline making assumptions around the % of  total costs are variable costs. Clearly, the lower your EBITDA margin the more rapid the change in leverage. Looking at charts 1 & 2 the leverage high points would never be reached. Markets are likely to “call time” on anything above 8x.

This post has just considered leverage and EBITDA. The realities of working capital, government support schemes, renegotiation with suppliers and customers complicates the reality associated with cashflows (and model risk).

What does this all mean? More work for Bond investors..

• Stress testing models and working out the margin for error relative to your base case is essential
• Knowing how much secured debt can be put ahead of you, what covenants, if any will be
• Bond maturities are real – perhaps the hunt for yield keeps refi’s alive but issuer specific risks cannot be ignored
• Use hefty discounts on asset valuations when thinking about recoveries
• Think about competition as lock down is lifted – will market participants remain disciplined?
• Think carefully about relative value – odds are things get cheaper, “apples vs. apples” comparisons are nigh on impossible right now.

Ultimately, Investors are are going to have to show some kind of forbearance to the companies that they have lent -waiving covenants, extending maturities, tolerating downgrades. In some cases increasing portfolio risk limits.

How do investors stop this from being a one way street?

• Being given security over assets
• Demanding tighter covenants – the return of “Maintenance” covenants is a great place to start.
• Consent fees are not practical given liquidity needs, but and OID or original issue discount is incentive
• Requiring increased reporting/ updates
• Increasing Sponsor participation – having additional new debt matched with Sponsor equity

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