U.S. corporates’ revenues, operating earnings and margins have recovered after bottoming in mid-2016.
- High corporate leverage is worthy of concern, but much of the risk is idiosyncratic and prudent credit selection will allow investors to continue to capitalize on opportunities in the space.
- While ratings could continue to migrate downward, only a limited proportion of investment grade credits are under review for downgrade from the ratings agencies, and some upward migration could occur as well. Ratings risks should be carefully monitored in both BBBs and single-As.
- The tumble in oil prices, the concern over tariff/trade negotiations, the rising labor and input costs, and the California wildfires have contributed to spread volatility in recent months.
- However, in a ray of good news for the corporate sector, we may be turning the corner on the credit cycle, as equity performance is becoming more linked to balance sheet strength.
With price declines of corporate bonds in the headlines, we assess some of the risks that have sparked concern from investment grade (IG) investors. High corporate leverage, downward ratings migration and various macroeconomic trends are three of the main factors that have pushed high grade spreads wider.
High Corporate Leverage
IG leverage has risen largely because corporate management teams have taken advantage of low rates to perform aggressive mergers and acquisitions (M&A). What’s different in this cycle is the large scale of the M&A deals. IG companies that issued debt to fund M&A in the last year saw total debt grow 44 percent, versus less than 1 percent for all other companies.1
Strong operating earnings, tax cuts, loose monetary policy from global central banks and steady growth in the U.S. economy have supported cash flows and allowed companies to comfortably service higher levels of debt. However, some chinks in the corporate armor, including rising financing costs and slowing global growth, may challenge some companies’ ability to avoid ratings risk or delever going forward.
While 3Q18 real GDP growth remained strong at 3.5 percent, it eased from 4.2 percent in 2Q18.2 Tariff/trade conflicts, the transition from quantitative easing to quantitative tightening, geopolitical risks, or other macro issues could curb U.S. growth in the near term.
Current gross leverage of 2.4 times is already near a record high3 but, if the U.S. economy stagnates, leverage could go even higher. Gross leverage is lowest among AA-rated credits (1.1 times), followed by A-rated credits (2.3 times) and BBB-rated credits (3.4 times).4 History shows that leverage problems tend to be exacerbated during economic downturns (Figure 1). Figure 2 shows that if EBITDA were to drop in a fashion similar to the average earnings decline in prior recessions and slowdowns since 1989, IG leverage could break records, although active deleveraging (e.g. asset sales, dividend cuts, etc.) would be expected to partially offset the increase.
While the overall higher leverage could drive more concern from investors and Fed policymakers, it’s important to look beneath the surface at distinct issuers. The growth in leverage is largely due to more individual issuers seeing debt swell to reach at the highest “tails” of debt in the IG space. Specifically, the proportion of issuers with leverage greater than 4 times has more than doubled since 2011 (Figure 3).5 This has occurred primarily because of jumbo M&A deals that have caused leverage to increase sharply in some of the largest IG credits. In A Closer Examination of Passive Fixed Income Investing, we explained that the corporate bond weightings of fixed income indices are based on the market value of a company’s outstanding public debt. Therefore, as certain companies have taken on heavy debt loads to back M&A they have garnered a greater share of the Bloomberg Barclays U.S. Corporate Investment Grade Index (the Index).
For example, leverage at CVS Health (Baa2(NEG)/BBB(STA)) will increase from about 3.3 times to about 4.5 times following its acquisition of Aetna Inc.6 CVS now makes up 1.15 percent of the Index, versus 0.16 percent at the start of 2007.7
United Technologies’ (Baa1(STA)/BBB+(NEG)) leverage increased from 2.1x to 3.5x following its acquisition of Rockwell Collins. That company is now one of the top 20 holdings in the Index (at 0.58 percent), versus 0.40 percent at the start of 2007.8
General Electric Co. (Baa1(STA)/BBB+(STA)) and AT&T Inc. (Baa2 (STA)/BBB(STA)) have been two of the top holdings in the Index for many years.9 Leverage rose from about 2 times to over 4 times at GE, and from 2.5 times to 3.5 times at AT&T over the past year mainly due to acquisitions.
Beyond credit risk, large debt-financed M&A can have important second-order effects on pricing for the acquirer and target. When a new jumbo (+$10 billion) bond deal comes to market in a sector, the trading volume (turnover) for other bonds in that sector falls by 8 percent in the year following the deal.10 That’s because the newly issued debt is more liquid, and investors typically use more-liquid names to express their views on the sector and the market. This can be beneficial in times when IG credit sentiment is positive; for example, the most-liquid bonds led the IG rally in July.11 However, it could also mean that more-liquid names could be more challenged when market sentiment starts turning down. Barclays noted that in the first half of 2018, the high liquidity of the Finance sector likely contributed to a lag in the sector versus the overall Index.12 Credit stress in a large-cap index issuer may turn the virtue of liquidity into a vice as creditors seek to hedge exposure to a highly indebted company. This further illustrates that thorough, bottom-up, active management is a prudent step in managing price and ratings risk in IG corporates.
Downward Ratings Migration
The proportion of BBB names in the Index has risen to just under 50 percent, versus 35 percent at the start of 2007. We think ratings will continue to migrate down, but that the magnitude of the downgrades should be manageable for IG investors. Using the $6.4 trillion Bank of America Merrill Lynch IG Corporate Bond Index as a market proxy, about 85 percent of the issuers have a stable outlook, per Moody’s.13 In addition, Figure 4 shows that potential upgrades and downgrades are relatively balanced and a majority of the possible ratings activity is expected among speculative grade issuers. As weighted by face value, only 8 percent of IG corporate issuers have a negative outlook, while 7 percent have a positive outlook. While outlooks don’t always drive rating changes, they are indicative of trend and likely magnitude.
The IG rating category with the most issuers with a negative outlook is the BBB- sector (13 percent of total BBB- issuers are on negative outlook). This is not surprising given the high growth in BBB- debt issuance during this cycle. It could indicate that fallen angels may increase during the next recession.
However, we note that as BBB- credits drop into high yield, despite a near-term performance hit, this drop could be positive for the IG Index over time as the most over-leveraged and poorly managed companies move to speculative grade. In addition, the Banking sector remains concentrated in BBBs. Given banks’ efforts to improve capitalization, there could be upgrades from BBB to single-A in the Banking sector.
Also, we think that investors should closely watch for ratings stress in single-A bonds. In fact, two of the three worst credit performers year-to-date are credits that have fallen from single-A to triple-B (Pacific Gas & Electric and GE).14
While aggressive M&A has driven the downgrades, corporates have typically stated a goal to maintain IG ratings despite the transaction. For example, CVS said that its leverage would decrease to roughly 3.6 times within two years of its acquisition.15 However, Barclays noted that single-A bonds tend to pay down their acquisition debt more slowly than their BBB-rated peers (Figure 5).
For investors, the key is to distinguish which names have strong free cash flows that can meet the debt reduction schedules required to maintain their IG ratings.
Several macroeconomic trends have also caused spreads to widen. Oil prices have fallen more than 30 percent quarter-to-date,16 and the oil price rout has led to underperformance in Energy spreads month-to-date.17 In addition, California wildfires have negatively impacted Utility bonds.18
Also, across sectors, rising costs have weighed on sentiment. Increasing labor costs and input costs were a main theme of 3Q18 earnings and outlooks (Figure 6). While earnings have remained strong, profit margins fell 20 basis points (bps) in 2Q18 after peaking in 1Q18.19 Higher costs could further squeeze margins down the road. Rising tariffs and barriers to trade are a go-forward risk to corporate profit growth.
The Beginning of a Deleveraging?
The credit cycle is driven primarily by debt growth relative to growth in cash flows and is typically coincident with the broader economic cycle. For the past several years, we have been moving through a declining credit phase characterized by rising debt leverage, record M&A activity, high share buybacks and dividends, and credit downgrades. The credit cycle has been prolonged by loose monetary policies from global central banks. As leverage has increased and shareholder enhancements and profits have risen, equity market valuations have ballooned.
However, from 2016 to 2017, the one-year stock performance of equity-funded M&A deals has outpaced that of debt-funded transactions.20 And, IG companies that have been involved in debt-financed M&A are giving more focus to halting share buybacks, flatlining dividends and utilizing free cash flow for debt reduction until stated leverage targets and credit rating goals are achieved. In 3Q18, dividends and share repurchases leveled off after growing through 2017. S&P 500 dividend cash distributions are forecast to rise 6.9 percent year-over-year in 3Q18, after rising 11 percent year-over-year in 2Q18.21
The Energy sector is a good illustration of how bond prices can be impacted by a shift in management posture. After oil prices plummeted between mid-2014 and early 2016, the Energy sector focused on bondholder-friendly goals such as reducing debt and shoring up liquidity through such efforts as halting dividends and issuing equity. Gross leverage in the sector peaked in 4Q16 at 4.7 times but has since fallen to 2.8 times as of 2Q18, per JP Morgan. The Energy sector has outperformed the Index since the end of 2016.22
Now, we are starting to see a nascent deleveraging focus take hold in other industrial sectors.23 This is partly because the large scale of recent M&A transactions has pushed ratings agencies to require the acquirers to commit to debt reduction or sell assets to maintain IG ratings and/or avoid a ratings downgrade. We continue to emphasize bottom-up research that includes an in-depth look at whether management teams prioritize short-term growth more than long-term, sustainable performance (see The Short-Termism Debate Heats Up).
Overall, we think today’s credit environment still offers opportunities in IG corporates for long-term investors. While price and ratings risk has ticked higher and thoughtful credit selection has increased in importance, default risk for IG corporates remains near zero. On average, it takes 28 years for an IG credit to default, and no IG defaults have occurred in the past six years.24 To manage volatility, deleveraging plans from large acquirers should be heavily scrutinized, and companies and sectors should be analyzed independent of the ratings agencies to determine which ones can best ride out any uncertainties in macro trends.
 Morgan Stanley, 2Q18 U.S. Credit Fundamental Review, as of September 7, 2018.
 Bureau of Economic Analysis, as of November 28, 2018.
 Morgan Stanley, CreditChartbook, as of November 5, 2018.
 Barclays, US Investment Grade Credit Metrics, as of September 19, 2018.
 Morgan Stanley, as of September 2018.
 Moody’s Investors Service, November 28, 2018.
 Bloomberg Barclays U.S. Corporate Investment Grade Index, as of November 26, 2018 and January 2, 2007.
 Bloomberg Barclays U.S. Corporate Investment Grade Index, as of November 26, 2018 and January 2, 2007.
 As of November 26, 2018, General Electric Co. made up 0.54 percent of the market value of the Bloomberg Barclays U.S. Corporate Investment Grade Index, making it one of the top 25 issuers in the Index; AT&T Inc. is the sixth-biggest issuer in the Index. In 2007, AT&T and General Electric Co. were among the top 20 holdings in the Index.
 “Big Fish Take Liquidity from Smaller Ones,” Barclays, August 17, 2018.
 Barclays, as of August 3, 2018.
 Barclays, as of July 31, 2018.
 ICE BAML Index data, CreditSights, Moody’s Investors Service, as of October 26, 2018.
 Barclays, as of November 26, 2018. Based on the Bloomberg Barclays U.S. Corporate Investment Grade Index. Performance ranked by excess return.
 Breckinridge Capital Advisors and CVS. Per a CVS 8-K filed November 19, 2018, CVS’s acquisition of Aetna is expected to close after the Thanksgiving holiday.
 Bloomberg, WTI oil prices, as of November 23, 2018.
 MTD as of November 26, 2018, the Bloomberg Barclays U.S. Corporate Investment Grade Index has seen excess return of -0.73 percent. The Utility segment of the Index has fallen 1.23 percent, while the Energy segment has fallen 1.74 percent.
 MTD as of November 26, 2018, the Bloomberg Barclays U.S. Corporate Investment Grade Index has seen excess return of -0.73 percent. The Utility segment of the Index has fallen 1.23 percent.
 JP Morgan, as of August 24, 2018.
 Debt-Funded Acquisitions Lose Their Luster, Barclays, as of July 27, 2018.
 Song, Wendy. “S&P 500 Dividend Payouts Increased 6.9% in Third Quarter.” Bloomberg, as of October 2, 2018.
 On an excess return basis, the Bloomberg Barclays U.S. Corporate Investment Grade Index has seen returns of 1.599% from 12/31/16 to 11/23/18. The Energy segment of the Index has seen returns of 2.072% over the same period.
 Kochkodin, Brandon, Bloomberg, Deleveraging is the Word of the Day Among Russell 3000 Companies, November 28, 2018.
 Among all global corporate defaults in 2017 that were originally rated IG, the average time between the first rating and the default was more than 28 years, per S&P (only five of the 95 corporate defaults in 2017 were originally rated IG). S&P’s database begins with all active ratings as of December 31, 1980, and two of these defaulters have this as their first ratings date. If S&P were to use the actual first ratings date, the time-to-default would be even longer. Cumulatively, from 1980 to 2017, only 0.3 percent of credits originally rated AAA defaulted; 1.1 percent of AAs; 3.7 percent of As; and 7.7 percent of BBBs.
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