Record corporate debts – a covenant warning signal?

Some £390.7bn in outstanding payments were recorded by Link Asset Services, an increase of 69 per cent from the previous low of £231.2bn in 2010/11, as companies paid down debts after the credit crunch.

The report also found that weak profits in recent years meant some of the borrowing was being used to prop up dividend payments to shareholders.

There has been a long-running theme – and you’ve seen this in the UK but very much in the US – about companies essentially increasing their debt levels and returning capital to shareholders

Donald Fleming, RSM

But while debt has never been higher, other metrics of corporate vulnerability compare favourably to the landscape immediately prior to the global financial crisis.

Gearing, the measure of debt relative to equity capital, was 73 per cent over the last year and falling, compared with 89 per cent in 2008/9.

Similarly, low rates mean interest costs consume just one-eighth of operating profit, a significant improvement from the previous year. Companies are also less reliant on short-term borrowings.

Take a sponsor-specific approach

Of course, aggregate statistics cannot speak to the health of individual DB sponsors. Some debt-raising may be covenant-enhancing, according to Tom Lukic, a director at Dalriada Trustees.

“Raising debt to invest in the business or alongside an equity raise on a sensible mix to fund strategic acquisitions can be beneficial to the longer-term covenant,” he said. “It’s having a sustainable level of debt, at a level manageable in a ‘downside scenario’ and within a balanced capital structure, that’s important and this will vary by business and by scheme.”

However, Lukic said that trustees should keep a close eye on their sponsor’s leverage levels, in line with their integrated risk management framework.

“Future interest rate rises could put pressure on more highly leveraged businesses, but also impact on the scheme funding position,” he said. “Trustees should be able to understand the risk posed to their scheme by future rate rises and look to put in place actions to mitigate where of concern.”

Source: Link Asset Services

The level of debt and gearing in UK plc varied significantly by sector. Consumer goods accounted for nearly a quarter of the UK’s debt, while oil companies’ net debt recovered slightly after skyrocketing in 2016/17. In both cases, the figures were skewed by large companies such as British American Tobacco and BP.

Some companies, such as utility providers, can operate under high levels of debt without much cause for concern, according to Donald Fleming, partner in the restructuring advisory practice at audit, tax and consulting company RSM.

Trustees, then, need to develop an understanding, with the help of their advisers, of how their specific company works and what might be a warning sign.

“You have got to understand from a treasury perspective, why does a scheme sponsor… finance itself in a particular way and what are the trends in its financing,” said Fleming.

Regulator may target debt-equity balance

The Pensions Regulator has made several explicit references to corporate dividend policies in recent publications, and trustees may want to be vigilant against debt raising that props up dividends without also strengthening funding levels.

“There has been a long-running theme – and you’ve seen this in the UK but very much in the US – about companies essentially increasing their debt levels and returning capital to shareholders,” observed Fleming.

Richard Favier, trustee representative at Dalriada, said the regulator's interest in dividends being paid instead of contributions was plain to see. “To further invite displeasure by paying such dividends with borrowed money would be foolish,” he added.

Usually thought of as a more pressing issue for investment committees than trustees with a focus on sponsor strength, Fleming also said the increasing trend for corporate borrowing to be done with less restrictive financial covenants could also present a problem.

“Trustees have got to be on the ball,” he said. “They can’t say, ‘What was your last quarter’s compliance with your financial covenants’ because [the sponsor] might not have any.”

Investment issues can be dealt with

Rising debt levels coupled with interest rate rises could also have an impact on pension scheme investment, particularly given the increasing reliance on fixed income among DB plans.

“Greater indebtedness and rising yields are likely to have a negative impact on bond prices,” said Ben Gold, head of investment, Leeds at XPS Pensions.

However, he said that a move towards buy-and-maintain strategies means schemes are less sensitive to price swings than previously.

Neither should schemes be too concerned about default rates if they have picked a bond manager who can avoid poorly performing companies. Rising interest rates make it harder for firms to service their debt, potentially leading some to fail.

“Schemes need to… make sure they are in assets where they can understand and accommodate the risk,” said Gold, but added: “Over the past 40 years the average impact of default on UK investment grade credit has only been about 0.1 per cent of returns.”