By Greg Haendel
It’s typically 70 and sunny in Southern California and there’s even a song “It Never Rains in Southern California” by Albert Hammond. One thing is for sure though and that is it will eventually will pour in Southern California. While it is still sunny and 70 degrees for investment grade corporate bond market fundamentals there are clouds on the horizon. Additionally the forecast calls for a storm of fallen angels over the coming years.
For those not familiar with some of the slick bond market lingo, a fallen angel is a bond that had an investment grade credit rating, defined as BBB- or better, and has since been downgraded to high yield, defined as BB+ or lower, due to weakening financial conditions or overleverage of the issuer’s balance sheet. Today let’s discuss this increase in leverage within investment grade corporate credit, identify some of the industries that could be most at risk of having fallen angels, and explore some companies that are pushing the leverage envelope.
Post the financial crisis, corporate America has been on a borrowing binge increasing debt from a little over $2 trillion precrisis to roughly $6.5 trillion today with almost $5 trillion of that corporate debt rated investment grade and 50 percent of that (roughly $2.5 trillion) rated BBB.
To further put these numbers into historical context, In February 1997, only 28 percent of investment grade debt was rated BBB. In February 2007, 38 percent was rated BBB. Today roughly 50 percent is rated BBB.
A number of factors have caused this borrowing binge over the last decade. Easier borrowing conditions and lower borrowing costs thanks to declining interest rates, as well as aggressive corporate share buyback activity and increasing M&A, have all contributed. The result is that non-financial investment grade gross leverage is almost 3 times, near a post-crisis high (meaning total debt is 3 times as much as annual EBITDA, or essentially operating income.) Excluding commodity-related companies, gross leverage is at a post-crisis high. In fact, there are few time periods when non-financial investment grade leverage has been higher—notably the 2001 and 2002 time period around the telecom and utility debacle.
But leverage must be examined in the context of a company’s ability to pay their interest payments on their debt, so declining interest rates and borrowing costs over the past decade should allow for higher amounts of debt—all else being equal. Unfortunately, debt and interest expense has grown at a faster pace than the decline in borrowing costs; interest coverage in investment grade credit remains near 11 times, near its lowest level post-crisis. In fairness, that is is still much better than that experienced in the 1980’s and 1990’s when interest rates were much higher.
While the increase in leverage and the percentage of BBB-rated companies can be alarming, not all BBB rated bonds are created, or rated, equally. The leverage increase over the last several years has been driven primarily by M&A activity, has been hiding primarily within non-cyclical industries and has been most pervasive in healthcare, food and beverage, telecom, media, cable, and technology.
Some of this is less worrisome, such as the leverage increase in technology companies moving from less than 2 times to slightly higher than 2 times, on average. But there are other industries where 4 to 5 times leverage, or even more, has become the norm, thanks to merger activity. In fact, roughly 14 percent of non-financial investment grade debt is leveraged more than 5 times; 9 percent is leveraged between 4 and 5 times. That's a combined increase of almost 10 percent over the last several years. A large amount of the increase is occurring within the food and beverage, cable and media industries.
In the past there were very few companies that had leverage over 4 times, let alone 5 times, that were not classified as high yield and rated BB or lower. Today, several companies engaged in M&A are pushing the envelope of leverage and receiving an investment grade rating by either promising significant leverage reductions in the years ahead, significant expense or revenue synergies from their deals, or securing a portion of their debt ahead of other unsecured debt holders.
A couple of noteworthy examples within the food & beverage industry include General Mills, Bacardi and Keurig. General Mills recently increased its leverage to roughly 4.5 times due to their acquisition of Blue Buffalo pet food. Bacardi recently increased its leverage to roughly 5 times in order to buy the remaining portion of Patron tequila it didn’t already own. Taking the cake within food & beverage, no pun intended, is Keurig Green Mountain and its pending purchase of the majority of Dr. Pepper Snapple Group which in turn will bring leverage to almost 5.9 times before accounting for synergies. While all of these companies have anticipated significant synergies and have promised rapid deleveraging, any corporate misstep, unforeseen competition, or macro-economic downturn or shock could derail their lofty deleveraging plans which in most cases have virtually zero margin for error. For example, a lack of innovation by General Mills or Amazon's planned move into pet food could create problems for General Mills. For Bacardi, the fickle tastes by consumers and rising popularity of alternative tequila brands, such as Casamigos, may make rapid deleveraging challenging.
Other noteworthy examples within cable and media include Charter Communications, Discovery Communications, and Comcast. Charter, which was already a high yield company, purchased Time Warner Cable in 2016 resulting in total leverage of 4.5 times although to achieve an investment grade rating on some debt, portions of the new debt financing as well as legacy Time Warner Cable debt was secured, thereby resulting in 3.5 times secured leverage and 4.5 times total leverage. Discovery Communications recently closed on their acquisition of Scripps Networks resulting in leverage of roughly 4.5 times with an aggressive yet achievable target of 3.5 times leverage in the near term. Last but not least, Comcast is allegedly preparing a $60 billion all cash bid for Fox, which if the deal is accepted and approved would increase Comcast leverage from roughly 2 times to almost 4 times.
While a recession is not in our forecast in the near term, the credit cycle is in its final innings as is evidenced by both the length of this cycle as well as corporate leveraging activity. Further, we continue to forecast increasing borrowing costs as a result of rising interest rates and continued fierce competition in several industries due to disruptors like Amazon. Adding fuel to the fire, approximately two-thirds of outstanding corporate debt must be refinanced in the next five years with the lions share rated investment grade and a significant portion concentrated within bonds rated BBB. Some of the companies pushing the BBB rated leverage threshold will be successful in their efforts to deleverage, although many will not. That will create a storm of fallen angels in the future. At Tortoise we believe that active fixed income management, strong fundamental analysis, and sound industry and issuer selection can help weather it. After all, not all BBB’s are created equal.
Greg Haendel is the Senior Portfolio Manager at Tortoise