Credit quality is showing signs of peaking

(Bloomberg) — In 2022, after the Federal Reserve began raising interest rates at the fastest pace in decades, some leading U.S. companies pledged to reduce their debt burdens. Those days may now be over.

BBB-rated companies increased their share buybacks in the latest quarter for the first time since early 2023 and accelerated capital expenditure growth after five quarters of slowdown, according to strategists at Barclays Plc.

Dividend growth also accelerated, strategists such as Dominique Toublan and Bradford Elliott wrote in a note on Friday. Meanwhile, interest costs are rising faster than a key measure of profits.

Add it all up and it appears that companies are becoming friendlier to shareholders and less friendly to bondholders.

“While there are no signs of impending distress, it appears the fundamental picture is likely past the peak of this credit cycle,” the strategists wrote on Friday, with weaker investment-grade companies turning away from “prudent balance sheet management” and focus on shareholders. payouts and accelerated capital expenditures.

Corporate bond investors have been piling on debt all year long, pushing valuations to near multi-decade highs and pushing spreads on investment-grade corporate bonds to near their tightest since the 1990s. The Barclays analysis underlines how market prices can become increasingly disconnected from the fundamental credit picture.

That doesn’t mean there will be a huge sell-off anytime soon. Gains are still relatively strong. Companies at risk of downgrading, i.e. at the A and BBB credit rating level, have generally reduced their debt levels, according to Barclays strategists.

If corporate bonds were to become much weaker, companies’ financial condition should continue to deteriorate and demand for these securities should fall significantly, says Seamus Ryan, director of credit research at GW&K Investment Management.

“To see a valuation reset from here on out, I think we really need a catalyst,” Ryan said.

Torsten Slok, chief economist at Apollo Global Management, thinks credit fundamentals remain robust and interest rates will continue to help attract inflows, he wrote in a note earlier this month. But with valuations already high, especially for less liquid corporate bonds, it makes sense for investors to switch to either more liquid corporate bonds or less liquid retail credits.

One reason for the increase in capital investment is artificial intelligence, which requires huge investments from utilities and energy companies, many of which have BBB ratings. Another likely source of weakening balance sheets is the expected uptick in mergers and acquisitions given incoming US President Donald Trump’s business agenda, with dealmaking likely to increase companies’ influence.

“Signs that animals’ minds are becoming higher are already present,” wrote Toublan’s team at Barclays. “We think next year these trends will continue.”

Production Note: Credit Weekly returns January 4.

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