With US GDP growing 6.4% at a seasonally adjusted annual rate in the first quarter, it is not surprising that companies have been delivering one of the strongest earnings seasons on record. If analysts are correct, the momentum should continue through the rest of the year, with earnings expected to rise by 36% in 2021 for the S&P 500, based on bottom-up IBES data, as at 25 May 2021.
Furthermore, the same analysts expect earnings growth to remain solid in both 2022 and 2023. Even though the make up of equity and credit market differs somewhat, the earnings outlook is broadly similar for corporate bond issuers.
In addition, the increase in bond yields earlier this year has had no real impact on the interest costs of companies. In fact, many companies managed to reduce their interest bill in the first quarter through refinancing existing, higher-yielding debt.
At the same time, credit spreads have continued to inch tighter and in some cases, have now reached levels last seen just before the global financial crisis. Because of that, investors should not become complacent. The danger is that good times can induce companies to take more risks, which can lead to a deterioration in fundamentals and problems down the line.
Below we look at the recent developments in corporate fundamentals and what could be areas of concern further ahead.
Strong earnings growth is enabling deleveraging
The latest data show that US investment grade (IG) gross leverage, the debt to earnings before interest, tax, debt and amortisation (EBITDA) ratio, ticked lower in Q1, continuing to fall from the record high.
Net leverage, that is debt adjusted for cash on balance sheets, has fallen even faster and is now lower than before the pandemic at 2.4x. This means that the gap between gross and net leverage is at a record wide, owing to the significant cash held on companies’ balance sheets.
However, deleveraging has not been universal across sectors. The figure below shows gross leverage in the US IG cyclical and non-cyclical sectors. While the leverage of cyclical sectors has been falling sharply since the middle of last year, the leverage of non-cyclical sectors has not budged much. What is causing this divergence?
First, the earnings of non-cyclical companies, as the name suggests, are less sensitive to the economic cycle. That is why a number companies, such as essential consumer goods producers or telecom companies, were less impacted by the pandemic. Hence, there is less of a need for active balance sheet repair.
Second, some of the non-cyclical companies have started to engage in debt-funded deal making, as the economic cycle is ramping up.
Overall, it is positive that the sectors hit hardest by the pandemic are seeing leverage fall because of strong earnings growth and reduction in debt. At the same time, the stalling deleveraging process in the non-cyclical sectors could eventually spill over to the broader market.
Across the Atlantic, leverage has continued to fall as well, following a similar path to the US. This shows that hiccups in the vaccine rollout in Europe and renewed lockdowns in some countries have not had too much of an impact on corporate fundamentals. With reopening now in full force again, earnings should start to really pick up, providing further impetus for deleveraging.
Interest coverage is improving
Similarly to leverage, the US IG interest coverage ratio – EBITDA to annual interest payments – continued to move higher, standing at 7.6x in Q1.
While recovering earnings are clearly a tailwind for interest coverage, there have been some interesting developments with the denominator of the ratio.
Namely, for the first time since 2005, US IG interest costs fell year-over-year in Q1. This is an impressive feat, indicating that the negative impact of higher debt levels has been cancelled out by the positive impact of a significantly lower cost of debt, as existing high coupon bonds are replaced by new low coupon ones.
Euro IG interest coverage ratio continued to rebound in the fourth quarter, standing at an impressive 10.8x. Even though euro are interests rates have been very low for some time now, companies continue to find ways to lower their interest costs.
Cash balances have likely peaked
While companies continue to carry elevated cash balances, the latest readings indicate that cash hoarding has likely peaked. In fact, US IG cash to debt ratio ticked lower in Q1, while in euro IG the ratio was unchanged.
The crucial question then is, what will the companies do with all the cash. Since a large share of the issuance proceeds have been earmarked for refinancing, companies should soon start to pay down the maturing debt with cash, thus leading to a shrinking gap between gross and net leverage. However, some of the cash could be put in other, less debt-holder friendly use.
Improving high yield fundamentals leading to ratings upgrades
Looking at the high yield (HY) part of the market, leverage is coming down as well. In fact, the damage caused by the pandemic is almost fully reversed in US HY, at least when looking at the net debt to ebitda ratio. As some of the lower rated companies have been under pressure to cut leverage, this is perhaps not a surprising development.
The brighter outlook for these companies has been also acknowledged by the credit rating agencies. In the wake of the strong earnings season, ratings agencies have started to upgrade HY issuers in volume. In April, the volume of US HY net ratings upgrades was at $45 billion, according to BofA Global Research, the highest amount in more than 10 years.
For investors, this is a very positive sign, as historically, the periods of net ratings upgrades have been associated with at least stable spreads.
The improvement in euro HY fundamentals has been somewhat less spectacular. While euro HY leverage has come down after peaking in Q2 2020, the decline seems to have slowed recently. This can, at least partially, be explained by the debt side of the equation.
So far in 2021, euro HY issuance has been very strong, far exceeding the volume at the same point last year. Given that defaults remained low throughout the pandemic in Europe, this could reflect investors’ confidence to purchase the bonds of euro HY issuers.
Potential dangers down the line
Overall, the opening up of the economy and swift rebound in earnings has been a powerful tailwind for corporate fundamentals. Paradoxically, however, it is strong growth and high confidence that could become a source of problems down the line.
In the aftermath of the global financial crisis (GFC), the corporate sector went through a protracted period of deleveraging. All signs indicate that this cycle will be very different. First, merger and acquisition (M&A) activity has picked up sharply in the US, with more deals also being financed by debt issuance.
Second, capital expenditures (capex) have increased substantially in the last few quarters. This is not surprising, given the capacity issues in many sectors and buoyant consumer demand. Capex was on area that was largely missing in the recovery from the GFC.
Third, as the cost of debt remains lower than the cost of equity, it would not be surprising if companies reverted back to the pre-pandemic trend of replacing equity capital with debt capital on the balance sheets.
Finally, many companies reacted to the pandemic disruption by cutting costs to protect margins. However, as input costs are now on the rise on the back strong demand, margins could start to come under pressure again, especially in lower profitability sectors.
That being said, the near term outlook should be more benign, with solid earnings growth, large cash piles, record low interest costs and ratings upgrades all being substantial tailwinds.