In focus

How stellar earnings are leading to rapidly improving corporate fundamentals


With the second quarter earnings season coming to an end on both sides of the Atlantic, it is 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 the expectations with ease. Should the momentum continue through the rest of the year, earnings will not only exceed the depressed levels of 2020, but will also be significantly higher than in 2019.

Below we look at the recent developments in corporate fundamentals in detail and what these developments mean for investors in corporate credit.

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 sharply in the second quarter. Deleveraging is facilitated by very strong earnings growth, with the trailing 12 month EBITDA increasing by almost 10%, the highest since 2011.

On the other side of the ledger, debt growth has cooled as well, even though it rose slightly in Q2. 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 2.4x, US IG net leverage is now back to its 2015 level. Finally, the persistently wide gap between gross and net leverage indicates that companies continue to hold significant amounts of cash on their balance sheets. 

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In Europe, corporate leverage continued to fall as well in the second quarter, albeit at a slower pace than in the US. This is because the rebound in earnings has been slightly less impressive in Europe, with the trailing 12 month EBITDA growing at 7.8%.

Debt growth, on the other hand, turned negative in Q2 for the first time since 2011. This indicates that European companies are perhaps taking a more active approach on deleveraging by looking for ways to cut debt.

With Europe now ahead of the US in the vaccine rollout and European economies finally emerging from lockdowns, earnings growth could get a further boost in the coming quarters. This would provide additional momentum for deleveraging. 

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Interest coverage is buoyed by strong earnings growth and falling interest costs

While leverage is moving down, interest coverage, as measured by the EBITDA to annual interest payment ratio, is moving up. 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 lower 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 increased sharply in the second quarter, now standing at an impressive 11.6x. Even though euro area bond yields have been very low for some time, companies still seem to find ways to lower their interest costs.

The US IG interest coverage ratio continued to rebound as well in the second quarter. While it is lower than in Europe, it has now returned to the pre-pandemic level.

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Cash balances have peaked but liquidity buffers remain large

While the gap between gross and net leverage indicates that companies continue to carry elevated cash balances, the cash hoarding has likely peaked. Cash levels fell slightly in Q2, especially in Europe.

Nonetheless, even if the absolute cash levels are slightly lower, companies continue to carry large liquidity buffers. Cash to short-term debt ratios are elevated, allowing companies to comfortably cover any near term debt payments.

The crucial question is, how all this cash will be used going forward. It is possible that some of it will be put in a less debt-holder friendly use. However, the only modest fall in cash balances so far indicates that most companies have taken a more cautious approach and have yet to decisively increase either capex or share buybacks.

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Record margins in the US

The strong earnings growth seen in the last few quarters is not only a reflection of the pick-up in economic activity. Equally importantly, corporate margins have recovered swiftly and are now at all-time highs in many cases. For example, the US IG EBITDA margin was at 28% in the second quarter.

Margins have been supported by two key factors. Early on in the pandemic, companies implemented cost cutting measures in the face of significant uncertainty. In the recovery phase, many companies have been able to benefit from rising prices of their goods and services.

Now, it is possible that margins have reached a peak and could even fall if rising input costs start to bite. Nonetheless, given the elevated starting point, there should be enough space for most companies to not feel the effects immediately.

In Europe, margins have exhibited much less volatility in the pandemic. The Euro IG EBITDA margin stood at 21% in the second quarter.

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Rapid deleveraging in the high yield market

Looking at the high yield (HY) part of the credit market, leverage is coming down rapidly. In fact, the damage caused by the pandemic has been more than reversed in US HY, at least when looking at leverage ratios. Net leverage has fallen from 4.4x in Q2 2020 to 3.3x. 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, as is 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.

Furthermore, the margins of HY companies have recovered rapidly as well. In fact, when excluding the energy sector, the US HY EBITDA margin is now the highest in the post financial crisis era. This should provide necessary leeway to deal with rising costs.

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The improvement in euro HY fundamentals has been only slightly less impressive. Net leverage has fallen from 4.8x to 3.4x because of a strong rebound in EBITDA growth. In addition, interest coverage is recovering fast, cash levels remain elevated and the EBITDA margin rose to a record high in Q2.

Strong earnings growth is leading to ratings upgrades

In sum, the combination of a swift rebound in earnings, very low bond yields and record margins has been a powerful tailwind for corporate fundamentals.

The brighter outlook of companies has been also acknowledged by the credit rating agencies. In the wake of the strong earnings reports, we have seen a significant volume of issuers being upgrade by ratings agencies.

In August, US HY net ratings upgrades were at $48 billion, according to BofA Global Research, the highest amount in more than 10 years. In Europe, upgrades have turned decidedly positive for the first time since the financial crisis.

For investors, this should provide some comfort, as historically, the periods of net ratings upgrades have been associated with at least stable spreads.