Fitch: Leverage Continues to Slowly Build at U.S. Captive Fincos

Leverage for U.S. captive finance companies (captives) ticked up for the third consecutive year in 2015, to an average of 7.1x versus 6.4x in 2012. With many captives at or near their internal targets, leverage could climb higher if earnings growth moderates, according to a new report from Fitch Ratings.

“Leverage rose slightly over the last year, and some captives could exceed internally-targeted levels, particularly in the auto space if there is performance pressure,” said Michael Taiano, Director at Fitch. “Nevertheless, average leverage remains below levels observed pre-crisis.”

Captives and their parent companies typically manage leverage ratios up or down through distributions or capital injections. In 2015, captives distributed a total of $1.6 billion in dividends, net of capital contributions, to their parents, up a modest 1% from $1.58 billion in 2014. Fitch believes the stable levels of dividend distributions reflected a need to retain capital to support loan/lease growth, particularly for the auto captives. In a scenario where captive leverage increased beyond targeted levels, the parent could elect to reduce distributions or inject capital, which would be viewed positively from the perspective of the captive, but would reduce financial flexibility at the parent company level, all else equal.

Normalizing credit performance and competitive pressure that compressed yields on new originations brought pre-tax profit margins down slightly to 28% in 2015, from 30% in the prior year. Nonetheless, portfolio growth remained robust as sales for most captives returned to all-time highs. Running counter to this trend, John Deere Capital Corp.’s portfolio contracted, as it was negatively impacted by the slowdown in the agriculture industry.

Fitch expects credit performance to normalize due to a modest loosening of underwriting standards, portfolio seasoning and lower recovery rates. Captive credit quality deteriorated in 2015, as average charge-offs modestly increased by one basis point year over year to 0.65%, while 60+ day delinquency rates increased to 0.60% from 0.54% over the same period.

“Profitability will be challenging for captive finance companies in the second half of 2016 as competition intensifies and credit performance continues to normalize,” said Taiano.

Positively, short-term debt issuance as a percentage of total debt stabilized in 2014 and 2015, after increasing in 2013. Commercial paper funding for U.S. captives included in Fitch’s report represented 21% of total debt at year-end 2015, unchanged from 2014. Fitch cautions that over-reliance on short-term funding, particularly if not accompanied by committed third-party liquidity facilities, increases refinancing risk.

The Rating Outlooks for all Fitch-rated U.S. captive finance companies are Stable following the revision of General Motors Financial Company, Inc.’s Outlook to Stable from Positive when its rating was upgraded to ‘BBB-‘ from ‘BB+’ on June 15, 2015 and Ford Motor Credit Co.’s Outlook to Stable from Positive when its rating was upgraded to ‘BBB’ from ‘BBB-‘ on May 27, 2016.

All Fitch-rated U.S. captives are equalized with their corporate parents, reflecting that Fitch views them as core subsidiaries. Fitch’s U.S. captive finance peer group includes:

–American Honda Finance

–Boeing Capital Corp.

–Caterpillar Financial Services

–Ford Motor Credit Co.

–General Motors Financial Company, Inc.

–John Deere Capital Corp.

–Harley Davidson Financial

–IBM Global Financing

–Navistar Financial Corp.

–Toyota Motor Credit Corp.

U.S. Captive Finance Companies: 2015 Review (Normalization in Profitability and Asset Quality Expected in 2016)