The rise in corporate leverage has been a focal point of discussion following the easy-money policies from the central banks. Indeed, it has been a point of contention for several years now (we published a small piece on the subject last year), particularly as investors search for the new ‘market bubble’ that could ignite the next financial market dislocation.
Specifically, there have been a number of reports on the growth of the BBB rated corporate sector. The expansion was partly fueled by large-scale M&A activity, debt funded share repurchases, and agency downgrades of sectors due to methodology refinements (i.e. the banking sector post-financial crisis).
Exhibit 1 below illustrates the situation causing concern. The share of BBB rated credit has risen to more than half of the broad investment grade index.
Exhibit 1: BBB rated bonds’ rising share of the US investment grade index
Source: Barclays Investment Grade Corporate Index (2000-2019)
In addition, the amount outstanding of BBB rated corporate debt is now twice the size of the high yield credit index (Exhibit 2). This observation is frequently referred to by those arguing for the bubble theory – they suggest that significant downgrades of BBB rated credit to high yield could lead to the high yield market being overwhelmed by the volume.
Exhibit 2: Volume of BBB rated credit instruments in the US relative to US high yield credit (USD millions outstanding)
Source: Barclays Investment Grade and High Yield Corporate Indices (2000-2019)
Over the last few years, BBB rated credit has benefited from an extended period of low downgrade rates, reflecting a supportive macroeconomic backdrop. The rate of BBB downgrades to high yield has been below the long-term average of 4.5% in eight of the last nine years – the 2016 oil stress being the exception (all data from Barclays indices).
The rise in leverage that has led to the growth in the number of BBB issuers has actually been driven by the more defensive sectors: real estate, utilities and consumer staples (source: Deutsche Bank Research). It has also been caused by a rise in the least-leveraged firms, mainly those in the technology sector.
While downgrades to high yield should be relatively muted in 2019, the current macroeconomic picture is more neutral than the tailwinds that have supported the market over the last few years. Supportive market factors include:
- the US Federal Reserve being on hold regarding rate increases and the ending of the balance sheet runoff later this year
- GDP growth slowing but still comfortably positive
- trade risks potentially receding
- high grade bond net supply likely diminishing (e.g. better technicals).
On the negative side, amid the global growth slowdown, corporate revenue growth is slowing and high corporate leverage debt keeps the market at risk if economic and/or earnings growth surprises to the downside. FactSet reported that analysts predict a decline in year-over-year earnings for the first quarter of 2019 (-3.2%) and low single-digit growth in earnings for the second (0.3%) and third (1.9%) quarters of 2019. These issues, as well as other late-cycle risks have the potential to pressure the credit markets as we move into late 2019 and beyond.
There are also more technical aspects of the BBB rating distribution to be considered. Firstly, the BBB rating covers a large swath of investment grade credit. The most-likely candidates to be downgraded to high yield are the BBB-minus issuers (only one notch from high yield). BBB-minus issuers have actually remained within the long-term average of the BBB rated distribution, that is 25%, compared to the 20-year average of 27% (data for Barclays indices). The lack of significant BBB-minus growth provides additional time for BBB-plus and BBB-flat issuers to demonstrate improvement in their credit profiles. This is explained by rating agencies preferring to downgrade credit by a single notch at a time (there are exceptions for material credit events that result in a substantially different capital structure or financial outlook). A downgrade from BBB+ to BBB is not as punitive in terms of spread widening as a downgrade from BBB to BBB-, the cusp of moving to high yield.
As noted above, the leverage of BBB rated companies often increases due to M&A activity. In a recent study, Barclays concluded that companies that have increased leverage for M&A transactions have historically reduced it very slowly, if at all. Furthermore, companies that engage in large debt-funded acquisitions generally do not return to pre-acquisition levels within three years of the deal. Despite this observable feature, the rating agencies have generally been fairly tolerant towards higher leverage at the outset of deals – and generally believed the companies would follow-through on deleveraging plans.
There have been some early indications of the rating agencies becoming more conservative in their post M&A leverage assessments. One example that is often cited is the Moody’s downgrade of Anheuser-Busch InBev (ABI) debt to Baa1 at the end of 2018. The agency said:
“The downgrade reflects Moody’s expectation that ABI’s leverage will remain high for the next few years. Moody’s expects free cash flow to improve due to the company’s recent 50% dividend cut and the benefit of cost savings. However, the company’s progress in reducing its high debt balance of over USD 100 billion will still be slow. Deleveraging is behind original expectations due largely to foreign currency fluctuations and underperformance of certain emerging economies.”
Following the downgrade of ABI’s debt, there have been several research reports highlighting other companies that are behind in their projected deleveraging schedule.
One benefit companies have been able to demonstrate is that despite the higher leverage from M&A, most have been able to lock-in low cost funding (amid the lower yield environment) and borrow longer in duration – pushing out the maturity wall. Therefore, while leverage has increased, interest coverage (i.e. EBIT/interest expense) has remained within what is considered acceptable for investment grade bonds. Agencies typically would cite this as a positive factor in maintaining an investment grade rating, despite the higher leverage.
Another M&A positive is that most recent deals have been strategic in nature (e.g. AT&T buying Time Warner) as opposed to a financial sponsor taking a company private. The leveraged buyout (LBO) trend was more pervasive before the financial crisis. A strategic acquisition can often highlight greater synergies and provide revenue diversification, which are viewed positively by the agencies.
Despite the possibility of the agencies becoming more aggressive, we believe that some of the largest BBB rated companies – which are generally more defensive in nature – have greater flexibility to salvage investment grade ratings. Most large companies can reduce dividends and share repurchases, cut capital expenditure and sell non-core assets for debt repayment. Of course, all of these remedies can be problematic in going against the wishes of shareholders – a complex equilibrium for companies to maintain.
The various issues impacting the BBB rated debt sector leaves us less concerned about large-scale downgrades to high yield – despite the ominous amount of BBB rated debt. However, there will be some sectors that have fewer levers to pull to maintain ratings (e.g. consumer retail). Therefore, it is important not to apply a “one size fits all” strategy to BBB rated companies, but rather to focus on the idiosyncratic factors that could affect the credit profile for certain sectors and issuers.