Synopsis of Corporate Fundamentals from IG Investment Quarterly: Enjoying the Ride
Stephanie Dontas, CFA
Every quarter, a team of our senior investors from across J.P. Morgan’s Global Fixed Income, Currency & Commodities platform gather to formulate our consensus view on the near-term course (next three to six months) of the fixed income markets. This blog highlights key points in the Investment Grade Credit space.
The bottom line from our latest Global Credit Investment Quarterly (IQ) review is that investment grade spreads are near decade tights, but the fundamental backdrop justifies rich valuations. Off-the-charts EBITDA growth has created the ultimate tailwind for investment grade corporates. Companies can’t help themselves but to de-lever, at least for the next few quarters.
Since the peak in leverage experienced in the second quarter of 2020, the combination of modest debt pay downs and soaring EBITDA growth have allowed both the U.S. investment grade and the European investment grade median industrial company to reverse the impact the COVID-19 outbreak had on leverage, at least on paper. As of the second quarter earnings season of 2021, the median global investment grade rated company has been able to decrease both gross and net leverage to pre-COVID levels. In fact, net leverage has recovered to levels we haven’t seen since late 2018 in both regions.
Quite impressive, right? We think so too. Investment grade companies have acted relatively conservatively and prioritized the balance sheet with excess cash flow - and it’s showing through in the data. Operating margins, an important measure of profitability in the face of rising inflation fears, are approaching 20 year highs. Shareholder payouts are still largely turned off or scaled down for heavily impacted COVID sectors. Some sectors have even started to funnel money that used to be paid out to shareholders pre COVID into other parts of the business, such as electric vehicle capex for auto companies. Cash balances are not as high as seen in the peak uncertainty of 2020, but are still sitting well above cash levels in 2019.
There is no question that part of the reason the market has been able to maintain such tight valuations in global investment grade spreads over the past few quarters is because of this strong fundamental backdrop. And, if one takes a look at the estimates for EBITDA growth through year end 2021, the music isn’t expected to stop – it is expected to get louder. Deleveraging efforts, fueled by unrelenting EBITDA growth, are expected to continue into year-end 2021, and into early 2022. Even when taking into consideration some positive debt growth going forward, fundamental improvement is highly likely to continue through year end if estimates for LTM (Last Twelve Months) EBITDA growth are realized.
When surrounded by all of this optimism, it is tempting to sit back, relax, and enjoy the ride. But, at the end of the day, we are still fixed income investors. Therefore we find ourselves asking the question - what could go wrong? As the output of the IQ has confirmed, we still put an 80% probability weighting on the expectation for “above trend growth” for several quarters going forward. Yet, growth acceleration has likely reached peak in Q2 2021 as we start to lap easy comps from 2020. We have seen some softness versus estimates in realized growth due to drawdown in inventories that haven’t been rebuilt yet because of supply chain bottlenecks. The delta variant is also a factor that could push out growth further into the future. Research analysts have flagged some sectors where higher labor costs, higher input costs, and/or supply chain disruptions are starting to create higher margin pressure versus what estimates are pricing in. The major risk to the strong fundamental backdrop for investment grade corporates is EBITDA growth underwhelming expectations.
Taking this into account, the GFICC Investment Grade Credit Team felt the estimates needed three major adjustments during this quarter’s presentation:
- We compared LTM EBITDA estimates versus GDP growth expectations through year end and dialed up or dialed down EBITDA growth to be more in line with the GDP output versus the depths of 2020, and also versus pre COVID levels. Importantly, we also wanted to reflect the risk of margins coming under pressure between now and year end. In the U.S., estimates were dialed down and in Europe estimates were dialed up marginally.
- Although it isn’t the “base case” according to estimates, we factored in modest positive debt growth, on both a gross and net basis, across both regions.
- We created a year end 2021 range of potential outcomes for net leverage instead of showing one data point based on estimates.
Valuations may feel rich in investment grade, but after taking a deeper look at the fundamental backdrop expected for the next few quarters, spreads are tight for a good reason. In the U.S. and in Europe, the investment grade market has not had corporate fundamentals improving at such a rate in years. Risks to the growth backdrop, margin pressures, and central bank policy are looming – but even taking into account a fraction of the EBITDA growth expected leaves companies in a good place fundamentally. Take a deep breath and enjoy the ride, while it lasts.