Corporate Fundamentals: Different this cycle
Since our blog last quarter, fundamentals for US companies have not changed materially, but the odds of a recession have grown markedly due to the Federal Reserve’s (Fed) response to sustained inflationary pressures. While fundamentals will likely weaken as the Fed tightens monetary conditions, we continue to believe that Corporate America – our investment universe of investment-grade and high-yield credits – has ample flexibility to weather the storm.
As shown in Figure 1, the pace of improvement in fundamentals for US companies has moderated, as we had expected. Year-over-year revenue and EBITDA growth is still positive for the median investment-grade and high-yield company at 16% and 18%, respectively, for the first quarter of 2022, but significantly lower than the peaks achieved in the post-pandemic recovery.
Figure 1: Moderating fundamental improvement in US Investment Grade and High Yield companies
Concerns about margin compression, which we had thought were more relevant to equity valuations than fixed-income credit fundamentals, have ballooned since our blog last quarter due to persistent inflation. As a result, the US Federal Reserve has begun tightening in earnest, increasing the Fed Funds rate by 50bps in May and 75bps in June and telegraphing future rate hikes. As the Fed fights inflation, the market has rapidly priced in more rate hikes and the likelihood of a recession. While the odds of a recession have increased, we note that corporate fundamentals are better than they were entering prior recessions. As shown in Figure 2, the ability of investment-grade and high-yield companies to service their debt is high, as shown by coverage ratios for the median company in each universe. As we have written previously, corporations 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.
Figure 2: Strong coverage ratios, especially compared to prior recessions
Operating Margins, US Investment Grade & EU Investment Grade
The recovery in balance sheets stalled last quarter, albeit at healthy levels. Balance sheet repair over the last two years has, of course, been driven by both EBITDA growth as well as declines in leverage. We disaggregate these for the investment-grade and high-yield universe in Figure 3. In addition to the EBITDA growth we highlighted above, Figure 3 depicts the decline in debt, as well as the more recent increase, for the median investment-grade company in the US. High-yield companies have also increased cash flow and decreased debt in the last two years.
Figure 3: Disaggregating the change in leverage
Figure 4: Lower leverage
Compared to levels entering prior recessions, leverage levels are mixed. As shown in Figure 4, leverage is now lower than it was when the US economy entered recessions in 2019 and 2000, but higher than leverage in the 2007 recession.
A point of differentiation from prior recessions is the current sustained difference between gross and net leverage, which reflects significant cash balances in companies. Figure 5 indicates that companies have maintained significant cash balances for more than a decade after the Global Financial Crisis. While cash balances remain high, they have begun to decline.
Figure 5: Cash balances remain elevated
How have companies deployed this cash? Following significant cuts in capital expenditures in 2020 and early 2021, as shown in Figure 6, companies are now increasing capital expenditures and expected to continue to do so.
Figure 6: Capital Expenditures – curtailed, but now rising
In addition to capital expenditures, companies, as expected, have been returning capital to shareholders in the form of dividends and share buybacks, as shown in Figure 7. We have written previously about the credit cycle and its progression from downturn to repair to recovery to expansion. The downturn caused by the pandemic was sharp and severe, but companies moved swiftly to repair their balance sheets, by curtailing capital expenditures, dividends, and buybacks. Moving from the recovery to the expansion phase, companies have been increasing their cash outlays, as expected. If another recession follows Fed tightening, we continue to believe that companies have the financial strength, flexibility, and discipline to withstand it.
Figure 7: Buy backs and dividends – curtailed, but now rising