Corporate fundamentals strengthen further amid earning growth and low yields
The corporate sector has recovered remarkably fast from the pandemic, but further improvement in fundamentals might not come as easy.
With the third quarter earnings season coming to an end, it is again time for an update on the state of corporate fundamentals.
Even though companies faced a high hurdle coming into the earnings season, most still managed to beat expectations. Not only are earnings exceeding the depressed levels of 2020, but are now higher than pre-pandemic in many cases. In addition, low bond yields have allowed companies to further cut their interest bills.
Below we look at the recent developments in corporate fundamentals in detail and what these developments mean for corporate credit investors in 2022 and beyond.
Strong earnings growth is facilitating deleveraging
The latest data show that US investment grade (IG) gross leverage, the debt to earnings before interest, tax, debt and amortisation (EBITDA) ratio, fell further in the third quarter.
Deleveraging continues to be facilitated by very strong earnings growth, with the trailing twelve month EBITDA increasing by 14%, the highest since at least 2000.
On the other side of the ledger, debt growth turned positive in Q3, albeit only marginally at 0.2%. This indicates that for most companies, there is not much need for active deleveraging through debt cutting, as buoyant earnings growth is doing the heavy lifting.
Net leverage, that is debt adjusted for cash on balance sheets, has fallen equally fast in the last few quarters. In fact, at 2.1x, US IG net leverage is now back to its 2015 level.
In Europe, leverage is falling as well, although at a slightly slower pace than in the US. This is because the rebound in earnings has been slightly less impressive in Europe, with the trailing twelve month EBITDA growing at 11%.
Debt growth, on the other hand, became more negative in Q3, coming in at -3.8%. This indicates that European companies are perhaps taking a more active approach to deleveraging by looking for ways to cut debt.
Interest coverage is buoyed by falling interest costs
While leverage is falling, interest coverage, as measured by the EBITDA to annual interest payment ratio, is either continuing to move upwards (US), or has stabilised at a very high level (Europe).
The swift recovery in earnings is clearly a tailwind for interest coverage, although developments with the denominator of the ratio have been equally important.
In both US and euro IG, interest costs are falling year-over-year. Since late 2020, companies have been aggressively refinancing their debt by replacing existing bonds with new ones with low coupons, to take advantage of record low bond yields.
The cumulative effect of rising earnings and falling interests costs is that the euro IG interest coverage ratio now stands at an impressive 11.6x.
US IG interest coverage ratio continued to rebound in the third quarter. Even though it is relatively lower than in Europe, it has now risen well above the pre-pandemic level.
Cash balances are falling
While the gap between gross and net leverage indicates that companies continue to hold significant cash piles, the absolute levels of cash have been falling in recent quarters.
Nonetheless, even if the cash levels are lower, companies have sufficient liquidity buffers, allowing them to comfortably cover any near term debt payments.
The crucial question is, how all this cash will be used going forward. Here, it is possible that some of it will be put in a less debt-holder friendly use, either through capex or share buybacks.
Margins remain strong despite cost pressures
The latest earnings reports show that on average, corporate margins remain strong, despite emerging costs pressures. US IG EBITDA margin was at 28% in the third quarter, only fractionally lower than in the previous quarter.
It is possible that margins have reached a peak and could even fall if rising input costs start to bite. However, given the elevated starting point, there should be enough space for most companies to not feel the effects immediately.
In Europe, margins have exhibited less volatility in the pandemic. Euro IG EBITDA margin stood at 22% in the third quarter, indicating that European companies have perhaps somewhat less space to absorb rising prices.
High yield leverage is well below the pre-pandemic level
Looking at the high yield (HY) part of the credit market, leverage is has come down fast in the last few quarters. In US HY, the damage caused by the pandemic has been more than reversed, judging by the leverage ratios. Net leverage has fallen from 4.4x in Q2 2020 to 3.4x. This is the lowest since 2014.
Unlike in IG where deleveraging has been mostly a function of strong earnings growth, companies in the HY market have been taking active steps to reduce leverage, illustrated by negative debt growth. As some of the lower rated companies have been under pressure to cut leverage, this is perhaps not a surprising development.
Strong economy and animal spirits could induce some re-leveraging
The combination of strong earnings growth, very low bond yields and record margins has been a powerful tailwind for corporate fundamentals. As we look ahead, the question is if the backdrop will remain as benign in 2022.
In 2021, we have seen record new issuance in both US and euro HY. What’s more, lower quality issuance has proliferated. For example, US HY leverage buyout (LBO) and mergers and acquisitions (M&A) related issuance is on track to break $100 billion for the first time ever.
As a result, US HY leverage excluding the energy sector actually increased slightly in Q3 (see the figure above). Faster debt growth might not necessarily herald imminent problems, especially if the economy remains strong, but is something to keep an eye on nonetheless. It is possible that leverage ratios will start to move up again in 2022, even if the earnings growth tailwind remains in place.
In investment grade credit, M&A related issuance was the key driver of the substantial build up in leverage between 2014 and 2018. So far in 2021, US M&A issuance has increased compared to 2020, but at $153 billion, it is still a fair bit lower than in the record years of 2015-2016.
One aspect that could perhaps curtail debt-financed M&A is the relative high share of BBB issuers in US IG index at 50%. This means that the pool of issuers that can afford to take on substantial debt without losing investment grade rating is lower than in the past.
Nonetheless, if the economy continues to growth at a steady pace, M&A activity is likely to pick up. With US CEO confidence elevated compared to history, the environment looks conducive for more deal-making.
A final point to keep an eye on is the path of bonds yields in 2022. For most issuers, bond yields can rise a fair bit from current levels before companies’ interest costs start to increase. This is because yields are below average coupons in all major credit indices.
However, the margins vary between issuers. For example, euro HY index yield is relatively close to average coupon, as euro HY has a relatively short duration at four years. So higher yields would have a more immediate impact in euro HY, in case issuers need to refinance their debt.
In sum, corporate fundamentals continue to improve, as the rising tide of strong growth is lifting all boats. However, it is important to monitor more vulnerable companies in order to know who could be in trouble once the wide has gone out.