In this second blog of a dedicated series on credit, we take a closer look at the current state of corporate fundamentals.
As the synchronized global economic expansion rolls on, the near-term economic outlook remains supportive for risk assets. Nevertheless, we need to be attentive to emerging signs of a shifting tide as the cycle matures.
For example, corporate leverage is approaching record highs, just as corporate profit margins are beginning to stall. Both of these factors make companies more sensitive to any negative earnings related announcements. Coupled with a sustained decline in the interest coverage ratio - an indication of a company's ability to meet its interest payments - these serve as good indicators of a marked increase in default probabilities in times of stress.
While, at the overall index level, current corporate fundamentals remain resilient and defaults are not expected to pick up significantly, the trend in leverage, profit margins and interest coverage suggests the pricing of spread assets should become more discriminatory as winners and losers are separated in an aging bull market. If so, this is typical of a late cycle environment in which the importance of active management becomes critical to safeguard capital by tactically adjusting the exposure to credit risk.
This post originally appeared on the BlackRock Blog.