Earnings Season: Corporate Prospects Will Be Particularly Interesting

Some erosion should not be interpreted as a major negative for holders of corporate bonds.

Investors entered 2022 amid concerns about high inflation in the US and Europe, supply chain challenges and expectations of Fed rate hikes; a negative feeling that was later reinforced by the war in Ukraine. Despite widespread macroeconomic uncertainty, the US corporate earnings season, which is about to begin, should bring more clarity as to the impact on margins, earnings and cash flow.

Earnings revisions are being watched: For the US market, analysts estimate earnings growth is expected to slow to around 9% year-on-year in Q1 2022, compared to 25% in Q4 2021 (the numbers are in this time supported by the post-Covid recovery). So we wouldn’t be surprised if there was pressure on margins or a drop in profits during this reporting season. The most exposed sectors are cyclical activities, such as automotive and transport, while, conversely, telecommunications and energy should be saved more.

A solid credit profile does not deteriorate overnight

The earnings revisions should be put in context: given record high margins, particularly in the US, some erosion should not be interpreted as a major negative for corporate bondholders.

In the current conditions of high inflation and faltering growth, companies have a solid profile, characterized by favorable ratios in terms of liquidity, interest coverage and leverage, both in Europe and in the US. They must therefore be able to withstand the current environment without major losses.

In addition, we expect the positive rating trend to continue in global credit markets. Key indicators, including corporate leverage, interest coverage, or targets for specific credit ratios such as cash flow to debt, reflect relative strength, supporting the rating agencies’ perspective. In our opinion, the number of rising stars must therefore increase.

Credit spreads widened from last year’s levels as average corporate bond yields more than doubled. However, the macroeconomic context has also changed and now incorporates greater risks. At the same time, delinquency rates remain very low as companies are generally in a sound financial position, which justifies tighter spreads.

From a bottom-up perspective, the banking sector maintains all its attractiveness, due to the solid levels of capital accumulated by banks over the last few years within economic models whose risks have been reduced. In recent quarters, US institutions in particular have been able to take advantage of favorable conditions: improving net interest margins, very low numbers of non-performing loans and solid earnings from market activities.

Also, in anticipation of rising yields, US bank bond issuance in the first quarter was higher than in previous years. This trend is expected to decelerate in the coming months, particularly after earnings season, which could eventually sustain secondary market bond performance.

Capital inflows confirm appeal of global corporate bonds

Investor demand is increasing for several reasons. On the one hand, awareness of the importance of investing on a global scale to effectively diversify sources of performance and risk. An approach focused on all global markets yields better risk-adjusted returns (measured by the Sharpe ratio) than local investments. This is a structural development, meaning investors are making a long-term commitment to the asset class. On the other hand, the comparison between yield levels in different regions allows identifying inefficiencies, for example, the increase in the attractiveness of the American market since the recent increase in yields in the United States.

Within a global universe, investors are more likely to identify pricing errors between bonds from the same issuer. Thus, securities of the same company, denominated in different currencies, often have price differences that constitute so many opportunities for relative value. By identifying the most attractive bonds in major currencies, investors can exploit market inefficiencies while benefiting from full currency hedging. These inefficiencies are due to differences in investment behavior across regions, as the investor base can vary between two bonds issued respectively in EUR and USD by the same issuer. The current market environment is accentuating valuation anomalies, and increasing dispersion in the global corporate bond market is creating opportunities for committed and active investors.

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