IG companies took advantage of economic reopening and easy year-over-year comparisons to post solid 2Q results, but headwinds are building.

Investment grade companies took advantage of the economic reopening and easy comparisons to report strong revenue and earnings growth in the second quarter. Cash-flow gains coupled with a slowdown in the pace of debt issuance also strengthened corporate balance sheets, with gross leverage now approaching pre-COVID levels. In many ways, IG companies have emerged stronger from the pandemic with more durable business models. Large companies with established supply chains, capital to invest and market-leading positions are dominating smaller, less diversified players.

As we approach third-quarter earnings, fundamentals are healthy, but the path forward is becoming less certain. Inflationary cost pressures and supply chain disruptions for many industries will become an increasing headwind, albeit masked by pricing action in the near to medium term. The healthy consumer balance sheet and strong consumer demand at this point in the cycle has allowed for price increases to flow through to end users with manageable impacts on volumes. The sustainability of that trend in the face of prolonged supply chain issues and structural changes in wages is uncertain.

Free-cash-flow generation also remains at peak levels, but this could dissipate as companies reinstate share buyback programs and look to grow their annual dividends. Another potential use of cash is M&A; however, we think that high valuations, COVID impacts on profitability forecasting, and increasing regulatory headwinds will mean that most deal activity could be “bolt-on” in nature. While instances where companies fund an acquisition with debt, resulting in a rating downgrade, continue to be the exception and not the rule, this needs to be monitored as the large cash balances that sit unused for a prolonged period will only invite investor criticism and potential activist interest.

Overall, our focus in the upcoming earnings season will be centered on how management teams are coping with the overreaching macro-related risks around COVID variants, inflation, supply-chain pressures and a slowing China growth outlook. This, along with a changing U.S. regulatory and policy landscape, could contribute to an environment that is ripe for elevated idiosyncratic risks. So far, these market pressures have not materially disrupted the investment grade credit market, and we continue to believe management teams will err on the conservative side of financial policy; however, the margin of error is becoming smaller with the easy year-over-year COVID comparisons now behind us and credit spreads at tight levels.

For more on this topic, read our latest Fixed Income Quarterly Outlook.