Jira Pliankharom
By Marcus Diaz
Credit metrics have likely peaked, suggesting that issuers’ margin for error is shrinking amid prospects for an economic slowdown.
In response to the initial COVID shock in 2020, companies took defensive action, shoring up cash balances through debt issuance and cost-cutting, pausing share repurchases, and scrapping plans for mergers and acquisitions. Demand recovered rapidly in 2021, fueled by fiscal stimulus, accommodative monetary policy, and the reopening economy. Companies effectively passed through higher costs from inflation to consumers, resulting in a robust fundamental credit backdrop; EBITDA margins and cash flow reached records, while leverage declined below pre-pandemic levels.
Strong economic growth in 2021 and a healthy demand environment entering 2022 served as catalysts for companies to allocate high cash balances toward capital expenditures, share repurchases and M&A. Companies used heavy capex investments to address supply chain issues and inventory mismatches, and accelerate onshoring of production. Share repurchases also increased considerably, given significant equity drawdowns this year. In the first quarter, year-over-year capex spending and share repurchases increased 19% and 84%, respectively. Similarly, M&A activity increased, with a pronounced shift in preference for cash deals in response to sharp declines in equity valuations.
Following the Fed’s pivot to tame inflation via rate hikes and quantitative tightening, the outlook for demand has softened as consumers navigate an environment characterized by fading stimulus, high inflation, and expectations for slowing growth. In the first quarter, we saw higher input costs, compositional shifts away from discretionary categories, and subsequent declines in guidance suggesting that credit fundamentals have reached a peak as critical metrics such as EBITDA margins, cash flow generation, and leverage see a reversal from recent highs.
Although we expect key credit metrics to weaken and cash balances to continue moving lower, we believe that many companies are starting from a position of strength. Throughout 2021, the average investment-grade issuer achieved record levels of profitability as EBITDA margins trended at about 19.5% versus pre-pandemic levels of about 18%, while gross leverage declined below 2.5x for the first time since 2015. Further, the largest BBB issuers operate in less cyclical sectors such as healthcare and telecom, which have good cash flow visibility. That said, we believe security selection should take precedence throughout the second half of the year when we expect impacts on credit fundamentals to vary significantly.
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