M&A: the risks and opportunities for credit in 2024

In a similar way to the economy, corporate activity is cyclical. Following the COVID-19 pandemic, low interest rates spurred a surge in merger and acquisition (M&A) activity, with 2021 witnessing the highest volumes since the mid-2000s. However, recent interest-rate hikes, economic uncertainties and banking sector concerns have dampened corporate confidence, leading to a significant drop in M&A activity last year. As we navigate through 2024, data suggests we may be poised for a resurgence in M&A and share buybacks. The question is to what degree volumes will return and what implications this will hold for credit markets?

The current landscape

In 2023, M&A volumes plummeted by over 30%, marking the lowest level as a percentage of US GDP (gross domestic product) in three decades. The instability of both the US and European banking systems (exemplified by the collapse of Silicon Valley Bank and Credit Suisse) contributed to lenders' increased caution, further stifling corporate activity. However, several indicators now suggest a potential rebound in M&A and share buybacks. Driving this will be improving corporate confidence, easing financial conditions and elevated cash reserves on balance sheets.

Factors influencing M&A and share buybacks

To forecast a recovery in M&A and share buybacks, it’s beneficial to understand where we are in the economic cycle. Historically, credit spreads and economic activity exhibit a negative correlation, with narrower spreads often indicating a more favourable environment for corporate transactions. Currently, US investment-grade (IG) and high-yield (HY) spreads are near their lows, suggesting a supportive backdrop for M&A and share buybacks.

Additionally, the correlation between corporate activity and US interest rates is noteworthy. Higher 10-year US Treasury rates often align with increased economic growth and, consequently, more share buybacks. Recession probability models, which have shown a declining risk, also point towards an impending uptick in corporate activity.

In Europe, credit spreads are wider compared to the US, although remain near historic lows. However, European shareholder activity typically lags the US, indicating a likely, but more subdued, increase in M&A and buybacks.

Implications for credit markets

The potential recovery in M&A and buyback activity raises questions about its impact on credit markets. Data suggests we are in a 'recovery' rather than a 'late cycle' phase, characterised by stronger earnings growth relative to debt growth. This phase typically sees more conservative corporate behaviour, with companies focusing on deleveraging rather than aggressive re-leveraging.

The higher cost of debt in the current environment is a significant factor. While lower interest rates in the past facilitated significant re-leveraging, today’s elevated rates and recent recession fears have shifted the focus towards reducing leverage. Despite a supportive M&A environment indicated by rising equity indices and falling equity volatility, interest-rate volatility has persisted, with sovereign debt investors still somewhat cautious. Indeed, with the weighted-average cost of capital at its highest in over a decade, companies have a strong incentive to reduce leverage.

Sector-specific insights

This incentive to deleverage will likely result in differing performance and corporate activity across sectors. The real estate sector, for instance, has experienced significant credit spread performance (tightening) in 2024 due to the need to deleverage. In terms of broader M&A activity, this has mainly been centred on larger deals in the US (>$10 billion). However, taking a logical, forward-looking view, sectors with lower leverage and stronger balance sheets relative to historical values are more likely to engage in M&A or buybacks. Energy, in particular, has seen increased activity driven by stronger balance sheets and moderate growth in US production, leading to consolidation.

Risks and considerations

While the activity outlook appears cautiously optimistic, several risks could temper the resurgence in M&A and buybacks. Political uncertainty, particularly in the US during an election year, could constrain corporate activity. Historically, M&A volumes tend to peak in the second half of election years, driven by sectors such as consumer staples and communication services. However, the political landscape's unpredictability might make companies hesitant to engage in significant transactions.

Regulatory scrutiny is another critical factor. Increased antitrust enforcement and regulatory hurdles could slow M&A activity, particularly in the banking, technology and healthcare sectors. Despite these challenges, structural drivers such as the clean energy transition, reshoring and the demand for digital capabilities could support higher volumes of strategic transactions.

Final thoughts…

Corporate activity is expected to recover from the subdued levels of 2023. However, the extent of this recovery will be moderated by the higher cost of debt and cautious corporate behaviour. Nonetheless, credit investors should remain vigilant. Certain sectors have experienced – and may continue to see – increased activity, requiring close monitoring to assess potential impacts.

The balance of cash versus equity funding in transactions and the strategic nature of M&A will likely mitigate significant credit rating downgrades or negative debt supply dynamics. The US remains, and will continue to be, at the forefront of M&A activity. However, as we move through 2024, the impact of economic, political and regulatory factors will likely shape the trajectory and volume of corporate activity.