June 11, 2019

Big BBB Downgrade Damage Ahead? Maybe Not

Why the anxiety about this overstuffed bond category may be overdone.

Reported by Larry Light

Art by James Yang

Will a dangerous swarm of BBBs sting the bond market badly? That’s the widespread fear, with a bloated 55% of investment-grade corporates crowding the BBB ratings category, which is situated right above junk bonds.

This situation stirs scenarios where, come the next economic downturn, a large chunk of BBBs will be downgraded, and shoved into the pit of junk ratings. Many insurers and some pension funds aren’t allowed by their internal rules to harbor high-yield credits, which might default and harm their benefit-paying ability.

Thus, the dire narrative goes, these institutions would have to divest the fallen angels, as companies downgraded to junk are called. And that would put downward price pressure on the entire bond market.

DoubleLine CEO Jeff Gundlach, known as the Bond King, has warned that massive corporate indebtedness, much of it concentrated in the BBB area, could bring about a catastrophe akin to the sub-prime mortgage collapse of the last decade. If the ratings agencies weren’t so forgiving, he says, 45% of BBBs would be junk-rated now. “The corporate bond market is so much worse today than it was in 2006,” he told CNBC last month.

In 2006, when interest rates were higher, investment-grade corporate bonds totaled just $1.8 trillion, with BBB 38% of that, or $700 billion. At the end of 2018, investment-grade overall had risen to $6.2 trillion, with more than half of it BBB, $3.4 trillion. The BBBs are twice as large, in dollar terms, as all of junk.

But is the proliferation of BBBs really a powder keg on the verge of exploding? While the next slump surely will prompt a spate of demotions to high-yield status from BBB, good reasons exist to believe that the damage won’t be that bad.

The swelling of Standard & Poor’s BBB category (Baa in Moody’s system) largely stems from companies leveraging up to make acquisitions in an era when debt is cheap. “A lot of the movement to BBB is voluntary,” said John McClain, a portfolio manager at Diamond Hill Capital Management. “Companies have been able to borrow cheap and the economic environment supported M&A.”

While some like Gundlach fault credit raters for not downgrading more BBBs to junk, another view is that many of these companies have strong fundamentals and should be able to weather coming storms. “The ratings agencies are patient, and we’ve seen just four fallen angels” this year, pointed out Jim Schaeffer, co-head of fixed income at Aegon Asset Management.

Investors can take comfort that a considerable segment of BBBs “can service the debt,” said Cameron Brandt, director of research at Informa Financial Intelligence. “Their cash flows are not bad at the moment.” Further, to stave off downgrades, a number of BBBs are deleveraging and holding down costs.

Right now, things don’t look very alarming for BBBs. The Bank of America BBB index is up 8.3% this year, after a flat performance in 2017 and 2018. That falls short of the S&P 500’s 14.6% year-to-date advance (despite a scary slide in May), an outcome you might expect since equities usually outpace fixed-income.

Yet the BBBs have thus far had a better 2019 than the broad-ranging Bloomberg Barclays US Aggregate Bond index, the fixed income benchmark that includes most bonds, notably Treasuries, asset-backed securities, and investment-grade corporates (not high-yield). The Agg has logged just 5.2%.

Why Investors Are Worried

Come the next recession, how big will the downgrades to high-yield be? The average amount of migration to below investment grade from BBBs is 11%, according to an Aegon study of the 10 worst downgrade years since 1970.

Such a shift, if we use S&P’s numbers, would mean $340 billion in market value added to the junk market, enlarging it by almost 25%. The Aegon study cautions that “the high-yield market may have increased difficulty absorbing the rising number of fallen angels,” although it also adds that it expects downgrade risk to remain manageable.

Such a massive transfer of companies to junk from BBB would trigger largescale divestitures from institutions like pension funds that can’t hold high-yield paper. “Then huge amounts of natural buyers would become forced sellers,” said Tony Waskiewicz, chief investment officer at Mercy Health (St. Louis). “That will bring significant price pressure on bonds, and you have to ask yourself: ‘How big a hit will my portfolio take?’”

One signal that the bond market is uneasy about BBBs is the volatility of the spread to Treasuries. The first sign of trouble arrives and the spread broadens. At the beginning of 2016, amid the gloom of an oil-price bust, the spread widened to 3 percentage points, then it fell to 1.2 during the buoyant outset of 2018, but at year-end blew out to 2.

“There was panic in the fourth quarter” last year, when investors got spooked by bad news over the trade war and a global economic slowdown, noted Dan Henken, a portfolio manager at Securian Asset Management. “And then came a rebound in the first quarter.” Now the spread is around 1.5.

The fate that awaits fallen angels isn’t pretty. The average spread for high-yield bonds is now 4.5 points. Getting demoted to junk is an ordeal for a company, as its borrowing costs escalate. That makes meeting its interest obligations and principal repayments more difficult, especially when a recession is choking off revenue.

The remedy of deleveraging BBB balance sheets has limits. Unfortunately, a deleveraging strategy doesn’t always work, and can be painful for shareholders.

Consider General Electric, which has had a horrendous time in recent years. The reasons range from ill-chosen acquisitions (drilling rigs amid an oil bust, for example) to over-reliance on its finance arm, which took a pasting in the 2008-09 market catastrophe and its aftermath.

“GE is in a no man’s land: It is a BBB, but the bonds can trade as if they were B,” said Phillip Titolo, a portfolio manager at MassMutual. In late 2018, a senior unsecured GE bond changed hands for 82 cents on the dollar, although the price since has improved.

GE has had some progress deleveraging, raising money to retire debt via asset sales. The company sold its signature appliance division in 2016 and in February agreed to sell its biopharma business. Long-term debt has been whittled to $94 billion as of this year’s first quarter, from $144 billion in 2015.

Yet debt still is too high. For GE, the ratio of enterprise value (equity and debt, minus cash) to EBITDA (earnings before interest, taxes, depreciation and amortization), an important valuation tool to assess a company’s broad capital structure, stands at a lofty 13. Levels below 10 are considered healthy.

The company has taken a familiar tack to please credit agencies—in the process, socking it to stock investors. In 2017, GE halted its stock buyback campaign aimed at bolstering the share price, after laying out $27 billion. That same year, it began slicing its dividend, then 24 cents a share; the payout is a penny now.

Benefit for GE: nada. Last fall, S&P cut the credit rating on the conglomerate to BBB+, with a negative outlook, from A. Over the past couple of years, the stock has tumbled by two-thirds, to around $10. Such lack of progress prompted the board to replace a company veteran as CEO with an outsider, Larry Culp.

Culp says his number one priority is to get the debt level down and the cash position up (it was $16.5 billion in the first quarter, double the level from six months before). The aim is to return to a single A rating. “We are not as nimble, we are not as agile, we can’t play as much offense as these businesses deserve with a balance sheet where it is today,” the new CEO told a shareholders meeting in May.

The outlook is no less dour at the automakers, where sales are slowing. Ford Motor ($11.5 billion in long-term debt) and General Motors ($14.2 billion) are both rated BBB. Meanwhile Fiat Chrysler ($15 billion), the sales laggard of the US Big Three, sits at BBB-, one notch away from junk. It has $9.4 billion in debt, but a negative free cash flow.

Why the Concern May Be Overblown

A decent case can be made that handwringing about the junk category’s inability to absorb a host of fallen angels may be excessive. For instance, the high-yield market may be bigger, hence more resilient, than some believe. Yes, junk bond issuance has been stagnant, because much of the leverage growth among below-investment-grade companies has been in leveraged bank loans, which are more flexible and often are less costly to issue.

That’s the argument of a paper by two Invesco staffers, Mike Kelley, the head of global high-yield research, and Samira Sattarzade, a senior analyst. “The US leveraged finance market, including loans, totals over $2.2 trillion in size,” they wrote, “which we believe is sufficient to absorb a potential uptick in fallen angels.”

And in fact, the Invesco researchers went on, 2016 shows how a fusillade of demotions to high-yield status isn’t always a disaster. That year was the last bad spell of downgrades, when a heavy volume of fallen angels sparked anxiety, due to an oil-price crash. Guess what? Junk bonds that year were buoyed by the turnaround in the oil prices, and high-yield enjoyed a total return of 18%, the best since before the global crisis.

More evidence that the expectations for a cascade of BBB downgrades may be just negative hype: A research paper from the Callan consulting firm argued that a large chunk of the BBB category—financials (12%) and consumer non-cyclicals (10%)—should have little trouble come a downturn.

Financials, it contended, “are better capitalized with healthier balance sheets post-GFC.” And consumer non-cyclicals (think food, beverages, pharmaceuticals, household products, tobacco) are “historically more resilient in times of economic slowdown due to their stable cash flow and lower sensitivity to discretionary spending.”

Further, the financial power of many M&A-driven BBBs is undiminished. A Goldman Sachs research paper found that “a large proportion of BBB-rated issuers have flexibility to preserve credit metrics and mitigate downgrade risks through asset sales, lower dividend payments or reduced capital expenditure.”

When Altria last year bought sizable minority stakes in e-cigarette maker Juul and cannabis purveyor Cronos Group, S&P, Moody’s, and Fitch promptly downgraded the tobacco giant to BBB. Nevertheless, “Atria has strong pricing power and huge free cash flow,” noted Diamond Hill’s McClain.

A consumer non-cyclical if ever there was one, Altria reported commendable free cash flow of $2.5 billion in the first quarter, along with robust revenue and net income. Both Juul and Cronos are profitable, with optimistic projections for the future.

The ultimate BBB test case is AT&T, whose gargantuan $184 billion debt load is the largest among nonfinancial companies. The $85 billion buyout last year of Time Warner, now WarnerMedia, is the latest and priciest of the telecom giant’s acquisitions, which includes DirectTV and more wireless spectrum capacity. The Warner deal, which heralds the company’s diversification-minded entry into the media and entertainment fields, compelled S&P to lower AT&T’s rating to BBB from BBB+.

Well, the telecom company is capping this expansion with a pledge to shed debt, announcing a goal this year of between $18 billion and $20 billion in trims. AT&T has sold its stake in streaming service Hulu and property it owns in the Hudson Yards development in New York, for instance. “We’re putting a stake in the ground” to reduce the debt, CEO Randall Stephenson pledged at an investment conference last month.

As it sports a strong free cash flow of $12 billion, a cash stash of $6.5 billion, and a solid enterprise value multiple of only 7.5 times EBITDA, it may well be able to pull that off. And along the way, forestall a shove into junk territory.

“If largescale downgrades occur” up ahead, Informa’s Brandt said, the outcome will be “short-term discomfort.” But a disaster? Demand will persist for the current BBB credits, he maintained, because they throw off decent income. “The market still has a hunger for yield.”