For treasurers and CFOs planning for 2021, the implications of the pandemic and other events on financial and risk-management policies have been profound. In this deep-dive article, we look closely at four key trends – and how they could influence corporate finance decision-making in the year ahead.
The year ahead should ultimately see the uncertainty and volatility caused by coronavirus subside to some extent (see our economic outlook here). Corporates should benefit from the actions they’ve taken in 2020, and while some enter 2021 in crisis mode, others will look forward to taking advantage of growth opportunities that may result from trends that the pandemic has accelerated.
While we don’t see core financial policies dramatically changing, we do expect a continuation and more permanent adoption of trends that have been set in motion by the pandemic. However, if 2020 has taught us anything, it’s that things can change very quickly: while 2021 should see the pace of change slow somewhat, it will still be significant.
It’s also important to remember that diversification and flexibility have been, and will always be, cornerstones of corporate financing, investing and risk management.
Corporate liquidity is likely to fall from peak 2020 levels but remain above pre-coronavirus averages
The mix of liquidity will be further skewed towards cash
The stop-start nature of lockdowns throughout 2020 compounded a sense of uncertainty and created difficulties for cash flow forecasting and launching new capex and opex projects. Corporates with an international footprint suffered extra complexity as they navigated lockdowns across multiple jurisdictions – factors that resulted in very prudent financial planning. What’s more, corporates often favoured cash to other forms of liquidity as it was more visible, fully in their control and uncovenanted.
As a result, liquidity for FTSE 100 companies has approached its highest level in recent history (see chart below), above the levels we saw during the Global Financial Crisis (GFC). Whilst vaccine news in recent weeks has been positive, we expect 2021 to offer new unknowns, including vaccine supply and efficacy, and further lockdowns. This will make cashflow forecasting more difficult than usual and encourage higher-than-average cash levels (albeit lower than in 2020). Positive vaccine news, access to capital markets and the strong performance and capitalisation of banks (compared with the GFC) will continue to see cash levels decline, with differences between sectors.
Liquidity positions1 of FTSE100 corporates through time (liquidity as % of sales)
While the Bank of England’s COVID Corporate Financing Facility (“CCFF”) and similar schemes provided liquidity relief early in the pandemic, activity since the first lockdown has been muted, with some suggestions a CCFF drawing was seen as a negative signal. Instead, central bank emergency funding lines were replaced with buoyant capital-market activity, including both refinancing and opportunistic pre-funding driven by constructive market conditions.
“Our analysis shows liquidity of around 18% of normalised sales is adequate to cover 95% of stress cases, but liquidity as at H1 2020 was 28% of sales”
To determine how much liquidity is deemed “enough” for FTSE 100 companies, our analysis – based upon historical sampling over the past 20 years – shows liquidity (including committed undrawn facilities and cash) of around 18% of sales is adequate to cover 95% of stress cases. The level as of H1 2020 was 28% of sales, but this is understandable: sales have been depressed following an unprecedented pandemic that continues to confront corporates with uncertainty, and we are facing a much rarer crisis. Although higher liquidity levels are unlikely to be required unless the economy materially worsens, there will be a shift in the corporate mindset from “defensive” to “opportunistic”, with capital resources a distinct competitive advantage for companies with acquisition and investment opportunities.
We see corporate liquidity reducing further towards (but not to) historical averages in 2021. We also believe the make-up of that liquidity will be more skewed towards cash than it has been recently, as bank financing is potentially more expensive and shorter-term. This means there should be greater corporate interest in longer-term deposits, ESG deposits, government and supra bonds, and commercial paper.
Target corporate leverage levels will remain broadly similar to pre-pandemic levels, with some corporates striving to return towards those levels and others positioning towards the lower end of their ranges
Opportunities to use cash, and the impact of leverage on equity returns, are key drivers for some corporates targeting the use of debt to fund growth
While many companies exceeded their leverage targets during the lockdowns, many acted quickly to remedy this through cash preservation and equity raising. As of year end 2020, FTSE 350 corporates had raised over £23 billion of equity since March*, far more than the around £2 billion that was raised during the first nine months of the GFC.
“As of mid-December 2020, FTSE 350 corporates had raised over £23 billion of equity since March, far more than the £2 billion that was raised during the first nine months of the GFC*”
*Source: NatWest analysis, Bloomberg
Going into 2021 we see many companies maintaining the same target leverage levels as before the pandemic. However, some corporates using a leverage range or ceiling (rather than a specific target) are signalling that they will aim for the lower end of the range in the near term. We think this approach will be supported by investors and stakeholders given ongoing uncertainties – and as more value is currently being ascribed to corporate resiliency than financial efficiency. This is likely to be a short-term measure, and we don’t expect many corporates to reduce their medium-term leverage or gearing targets.
In our view this trend is driven by:
(i) Opportunities to use cash
By year end, 49 FTSE 350 corporates had already reinstated dividends that had been cancelled or postponed, and we expect more to follow. We also expect M&A and investment activity to pick up as corporates that have thrived throughout the crisis use acquisitions to gain market share, enter new markets and position their businesses for the future. Meanwhile, corporates that have struggled to adapt following the crisis may seek defensive mergers.
(ii) The impact of leverage on equity returns hasn’t changed
Our analysis of the MSCI* Industrials index shows that the shares of more levered corporates (with net debt to EBITDA* of ≥ 2x) underperformed during the crisis. However, they have outperformed companies with less levered balance sheets since the GFC by around 60 percentage points (see charts below).
The increase in leverage after the GFC was partly driven by the rise of alternative investment vehicles, which generally have a stronger appetite for leverage, and historically low yields. Debt remains historically "cheap" and leverage is still a means to drive shareholder returns. This may be counterbalanced by new forces arising, such as potential fiscal policy changes(see our market outlook here), but it is unlikely to change the fundamental support for corporate leverage in 2021. However, we do expect a further move away from bank debt next year for mid to large corporates as they continue to diversify their sources of funding.
FTSE 350 equity issuances during the GFC
Share price performance for European corporates: MSCI Industrials (Europe)
*MSCI is an American finance company providing indices. EBITDA is earnings before interest, taxes, depreciation and amortisation.
Corporates will look to further diversify their sources of debt financing
Key drivers of this include limitations on bank capital and low bank return on equity, bank loan covenants and pandemic diversification lessions
The shift from bank funding to the bond market as the primary source of corporate finance has been a long-held goal of the European Union, one reinforced by the swifter recovery of the US (which has a deep and broad debt capital market) after the GFC.
The chart below shows the shift in Europe over the past 20 years. While coronavirus caused a substantial increase in loan market volumes in Q2, there has since been a rebound in the capital markets, including refinancing and opportunistic pre-funding driven by the need for liquidity and supported by constructive market conditions and central bank corporate bond buying. Going into the year-end, investment-grade yields are already below their pre-pandemic levels in Europe and the UK, and only slightly above in the US.
Eurozone corporates are gradually reducing their reliance on bank debt
We expect further diversification of funding for several reasons.
· Limitations on bank capital and low bank return on equity
Basel 4 measures, which require banks to hold more expensive capital and more low-yielding, high-quality liquid assets, alongside broadly flattened yield curves, are lowering banks’ return on equity. Banks have therefore been forced to become increasingly selective in their lending decisions. This has resulted in a pick-up in loan market pricing and reductions in tenor over 2020, making bank debt relatively less attractive than in recent years.
· Loan covenants are becoming stricter
Corporate treasury teams have spent lots of time managing their bank groups in 2020, with covenant waivers and documentation amendments not uncommon. Less restrictive documentation may be possible outside the bank market, and this will have strong appeal. Even in the high-yield space, and particularly for “fallen angels” (previously investment-grade corporates that have fallen to high-yield status), we expect covenant-light capital markets to be considered attractive even if they are more expensive than more heavily covenanted structures.
· Pandemic diversification lessons
Early in the pandemic, we saw corporates try to identify all possible sources of liquidity. For many, accessing the Bank of England’s CCFF or similar schemes elsewhere marked their first foray into the capital markets. Many corporates that previously did not consider commercial paper or the wider public capital markets as a funding option have established programmes that will remain alternatives to drawing down revolving credit facilities (RCFs). Similarly, corporates set up new legal entities in other jurisdictions to access other capital markets.
“By mid-December 2020, around £15 billion of CCFF drawings currently outstanding will become due in 2021”
By mid-December2020, around £15 billion of CCFF drawings currently outstanding will become due in 2021. Of course, capital markets will not absorb all refinancing – surplus cash and other deleveraging strategies will play their part. However, we expect corporates considering their refinancing needs in 2021 and beyond to think about pre-funding in the capital markets, or at least pre-hedging – given curve steepening risks and currently favourable funding conditions. Indeed, as inflation becomes a key consideration next year, corporates experiencing longer-term effects from the pandemic may suffer both wider credit spreads (due to a lower credit rating) and the risk of higher debt funding costs.
While credit spreads can be managed through an improving credit position (via debt reduction, asset disposals, hybrid and equity capital, and strategic initiatives), the risk of rates rising can be mitigated through opportunistic pre-funding. Capital markets and the macroeconomic backdrop remain supportive, and early 2021 should provide a window of opportunity to pre-fund upcoming needs.
There’s also ever-growing demand for green bonds as investors seek to lend to companies contributing to the United Nations Sustainable Development Goals. This is covered in an article by our colleague Arthur Krebbers, but the key point is the growing pricing benefit for green borrowing relative to non-green debt, and the ‘halo effect’ this can have – where the cost of all debt for the same borrower is reduced.
FX and interest rate risk managers will aim to lock in low rates and rates differentials, particularly in light of upside risks to inflation
The need for strategies that allow for cashflow uncertainties will continue
Inflation risks tilting higher will also be a key focus for corporate finance decision-makers
The focus of our customer conversations in 2020 was on cashflow and FX risks, while interest-rate risk has been less of a concern. Yet we’re already seeing interest expense coming back into focus, and this will continue as corporates delever, replace emergency funding lines and remedy surplus liquidity.
Nevertheless, 2020 was the year for foreign exchange risks. During the peak crisis periods we saw significant volatility in the FX and credit markets, impacting derivative pricing. Liquidity dried up, with bid-offers widening significantly and executable deal sizes falling. At times, GBPUSD and EURUSD spot FX spreads widened by over 3 times, GBPEUR by 5–6 times, and option volatility execution costs rose by up to 10 times.
During Q4 2020, corporates broadened their FX hedging policies in light of their experiences this year. We also saw them taking advantage of, and locking in, the lower interest rate differential (cost of hedging) between the US dollar versus the euro and sterling for transactional FX hedges. This will carry across to conversations about the currency mix of debt as interest expense comes back into focus.
Perhaps one legacy of coronavirus risk management will be that corporates consider FX options more closely. That could be in the form of vanilla options (which bring lower bank credit line utilisation) as a means of cheap protection against tail risks, or more structured options that can be used alongside existing hedging strategies to achieve better rates or reduce costs. Our projections (at the time of writing) are that the US dollar still has some space to depreciate against EUR and GBP, with the potential for sterling still to rise further in the near term against EUR following the trade deal although this optimisim will need to be supported by data fairly swiftly. Conviction on these views may lead corporates to hedge with forwards, depending on their exposure to each currency pair, an absence of such conviction could bring optionality into consideration.
“Using options avoids the potential for ‘naked’ mark-to-market losses on forwards if forecast cashflow exposures do not materialise”
However, one-year implied option volatilities for both EURUSD and GBPUSD are well below their five-year averages at the time of writing. Fragile consumer confidence makes corporate cash flow forecasting challenging. With implied volatilities where they are, options can provide cover for uncertain exposures at low cost in historic terms. Using options avoids the potential for “naked” mark-to-market losses on forwards if forecast cashflow exposures do not materialise.
Finally, we expect companies to focus more on inflation in 2021, not just due to the upside risks to inflation and its consequences on central bank interest rate policy (see our market outlook here), but also as corporates evolve. For example, Power Purchase Agreements (PPAs) and traditional property leases typically reference an inflation index. The shift to green energy (which PPAs can support) and diversification of funding for property and other large capex items may increase many corporates’ inflation exposure.
Year ahead 2021
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