As widely reported, corporate earnings for the second quarter broadly beat expectations across sectors and regions. Sustained improvement in revenue and EBITDA propelled continued advances in equity indices. Concomitantly, corporate financials continued to improve, as we projected in our blog last quarter. Figure 1 below depicts the marked improvement realized, on a quarter-over-quarter basis, in both US and European investment grade fundamentals.

Figure 1: Improving fundamentals in US and European Investment Grade companies

Source: ICE BofAML, Bloomberg, GFICC Quantitative Solutions calculations; data as of 12^th August, 2021

While a lot of attention has focused on improvements in year-over-year quarterly revenue and EBITDA, as shown in Figure 1, we thought it would be worthwhile to review the extent to which corporate health has improved versus pre-pandemic levels. We have highlighted previously the marked difference between gross and net leverage, as shown in Figure 2.  Notably, net leverage in US and European investment-grade companies was relatively stable from early 2019 through Q3 2020, but gross leverage continued to rise during that period as companies accessed low-cost capital, conserving much of it on their balance sheets.

Figure 2: Sustained deltas between gross and net leverage across regions

Source: ICE BofAML, Bloomberg, GFICC Quantitative Solutions calculations; data as of 12th August, 2021

Source: ICE BofAML, Bloomberg, GFICC Quantitative Solutions calculations; data as of 12th August, 2021

As shown in Figure 3, both investment-grade and high-yield companies have material cash balances, both as a percent of their outstanding debt as well as assets. Cash levels have declined somewhat from recent peaks as companies have begun to increase or reinstate dividends, share repurchases, and capital expenditures, as we had predicted.

Figure 3: Cash balances remain elevated

Source: ICE BofAML, Bloomberg, GFICC Quantitative Solutions calculations; data as of 12th August, 2021

As we have written previously, corporations have capitalized on low interest rates, refinancing debt to lower their future interest expense.  Lower interest expense and improving EBITDA have translated into enhanced coverage across investment-grade and high-yield companies in the US as well as European investment-grade companies.  We expect coverage levels, as measured by trailing-twelve-month adjusted EBITDA to interest expense, to continue to improve this year.

Figure 4: Improving coverage ratios

Source: ICE BofAML, Bloomberg, GFICC Quantitative Solutions calculations; data as of 12th August, 2021

With the marked improvement in operating fundamentals as well as balance sheet metrics, the rating agencies have reversed course from last year. As shown in Figure 5, the moving average of upgrades versus downgrades is sharply higher in both the investment-grade and high-yield universes.  As we have noted previously, emerging-market leverage levels were not as elevated going into the pandemic as those in developed markets.  Therefore rating agency downgrades were not as swift last year; upgrades in emerging markets have not been as robust either. While we continue to see opportunity for more upgrades, we expect the ratio of upgrades to downgrades to moderate.

Figure 5: Rating agency upgrades are outpacing downgrades

Source: ICE BofAML, Bloomberg, GFICC Quantitative Solutions calculations; data as of 27th August, 2021

As noted above, many companies are focused on reducing leverage; however, others are deploying excess liquidity to enhance shareholder returns.  We note that merger and acquisition activity is rising across sectors.  Notable deals include AerCap acquiring GE Capital, Canadian Pacific buying Kansas City Southern, Discovery acquiring WarnerMedia, and Microsoft purchasing discord. As a result, we continue to see idiosyncratic risk among issuers rising. Bottom-up fundamental research remains critical to successful investing across investment-grade and high-yield sectors.