Corporate Fundamentals: Where do we go from here?
Kay Herr, CFA
In 2021, across developed and emerging markets, corporations delivered significant revenue and EBITDA growth; indeed, absolute EBITDA now exceeds pre-pandemic levels. The pace of growth in both revenue and EBITDA has declined; we think it is likely that the improvement in fundamentals has peaked.
Figure 1: Improving fundamentals in US and European Investment Grade companies
Year-Over-Year EBITDA Growth
US and European Investment Grade
EM: 2021 rebound more than offset previous year’s decline
With the improvements in EBITDA noted above, leverage across developed and emerging market corporates, for both investment-grade and high-yield companies, is at the lowest levels seen in several years.
Figure 2: Sustained deltas between gross and net leverage across regions
High Yield Leverage
Emerging Market Corporate Net leverage at the lows
The gap between gross and net leverage remains elevated. As we have highlighted previously, and as shown in Figure 3, investment-grade and high-yield companies hold material cash balances in developed and emerging markets, both as a percent of their outstanding debt as well as assets. However, as we predicted, cash levels have declined somewhat from recent peaks as companies have begun to increase or reinstate dividends, share repurchases, and capital expenditures. We expect this trend to continue in 2022 with a resultant decline in elevated cash balances.
Figure 3: Cash balances remain elevated
Emerging Market Cash balance remained high in 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 ratios across investment-grade and high-yield companies in the US, Europe, and emerging markets. Capital markets were wide open in 2021; significant issuance across all fixed-income markets enabled companies to refinance existing debt, reduce future interest expense and extend maturities. With the prospect of rising rates and stabilizing fundamentals, we don’t expect further improvement in coverage levels, as measured by trailing-twelve-month adjusted EBITDA to interest expense.
Emerging market participants have expressed concerns about rising rates and the resultant risk to spreads. We are relatively sanguine about the impact of rising rates on overall funding costs for most of emerging markets. Implied funding costs have been quite stable for the last five years and rising funding costs mostly affect new debt. We estimate that a 20-basis-point rise in implied funding cost would cause a 0.26x decrease in interest coverage from 7.2x, which is a relatively modest change. Hence, interest coverage should remain solid.
Figure 4: Improving coverage ratios in developed and emerging markets
Emerging Market Corporate Interest Coverage ratio
With the marked improvement in operating fundamentals as well as balance sheet metrics, the rating agencies have reversed course from 2020. As shown in Figure 5, the moving average of upgrades versus downgrades is sharply higher in both the investment-grade and high-yield universes. We expect rising stars, credits that migrate from the high-yield index to the investment-grade index, in developed markets could reach USD200 billion over the next two years. 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
Figure 6: Margin expansion forecast to continue
Operating Margins, US Investment Grade & EU Investment Grade
One surprising trend in 2021 has been the continued expansion of margins. As shown in Figure 6, operating margins for investment-grade companies are at historic highs and continued to expand this year. Consensus estimates forecast continued expansion in 2022. Across developed and emerging markets, we are skeptical that margins will continue to expand. Companies face supply-chain disruption and cost pressures, some of which they are passing through to consumers; consumers may start to show resistance to increasing prices. The starting point for margins is incredibly strong, so both investment-grade and high-yield credits can withstand margin compression. In emerging markets, we expect margin compression in Latin America, in particular, after significant growth in 2021. Across developed and emerging markets, we expect resilience and the ability to withstand margin compression given the strong starting point.
If, as we forecast, margins compress in 2022, company management teams will need to rely on other levers for earnings growth. Not surprisingly, we have seen a resumption in share buybacks and increases in dividends. Another theme in 2021 has been the simplification of capital structures via spin offs and asset sales. Within the investment-grade universe, AT&T spun off WarnerMedia; J&J and Glaxo separated their consumer healthcare businesses; GE split into healthcare and energy companies; Novartis is selling their stake in Roche. While these have been credit neutral, the risk of corporate actions that are detrimental to bondholders, such as mergers or acquisitions or leveraged buyouts, is growing.
Following substantial appreciation in equity markets, we note that equity/market capitalization levels are at or near historic lows in the high-yield and investment-grade markets. As bond investors, our preferred metric for leverage is debt/EBITDA as it is not influenced by equity market values; however, equity investors may use the favorable debt/market cap ratios as an opportunity to increase leverage. As a result, we continue to see idiosyncratic risk rising. Bottom-up fundamental research remains critical to successful investing across investment-grade and high-yield sectors.
Figure 7: Net Debt to Market Capitalization