The Pollyanna View of Credit Markets Goes Mainstream

(Bloomberg Opinion) -- The bond market’s narrative around triple-B corporate debt has officially flipped. 

Last year, hardly a day could go by without another analyst highlighting the proliferation of securities rated in the lowest tier of investment grade and the elevated leverage among those companies. They had a point, of course — triple-B bonds surged to represent about half of the Bloomberg Barclays U.S. Corporate Bond Index, compared with one-third after the financial crisis. And it’s true that many of the largest companies that went on acquisition sprees would be rated junk if evaluated on their debt burdens alone. 

Now, the tide is turning. As I wrote a month ago, it seems as if many of the companies that migrated to triple-B did so by choice — nothing more than seeking the optimal capital structure at a time of historically low borrowing costs. Indeed, Fitch Ratings found that more than 90 percent of the companies it rates one or two steps above junk have a “financial flexibility” score that’s equal to or better than their overall mark. Investors have seen them use those other levers in recent days, in a move dubbed a “debt diet” by Bloomberg News’s Molly Smith:

General Electric Co. is selling its biopharmaceutical business to Danaher Corp. for more than $21 billion and using the money to pay down borrowings. Kraft Heinz Co. said last week it was slashing its dividend and using the proceeds of asset sales to reduce its liabilities.

Randall Stephenson, AT&T’s chief executive officer, said last month that the company’s top priority in 2019 is to lower its debt. Plans like these are good news for bondholders who have spent years watching these companies borrow ever more to finance moves like acquisitions that are designed to boost share prices, said Brian Kennedy, a senior portfolio manager at Loomis Sayles & Co.

“They’re in credit repair mode and going full force at this,” said Kennedy. 

This sort of reversal was hardly unexpected as long as investors tuned out the cacophony of doomsayers. In June, when triple-B corporate bonds were in an unprecedented spot of declining more than top-rated securities and junk debt, I wrote that the market was working to prevent even steeper losses in the future. In November, I said that sentiment had become far too bearish on triple-B bonds and that investors need not worry about a doomsday that everyone else sees coming. That put me in the camp of Hans Mikkelsen, the Bank of America Corp. strategist who Smith quipped seemed like “the Pollyanna of credit.”

Well, the cheerful mood seems to be turning into the consensus, just two months into the new year. In January, the confidence came largely in the form of demand for new triple-B issuance from companies like Anheuser-Busch InBev NV and Fox Corporation. By February, investors were willing to go on the record to say they’re not so scared after all:

Feb. 12: Investor concerns about the ballooning of BBB rated debt are overdone and the risk of a wave of downgrades into junk as the economic cycle turns is “greatly overstated,” according to TwentyFour Asset Management.

Feb: 15: The risk of a wave of investment-grade bond downgrades to junk is overblown, according to BlackRock Inc.’s Jeff Cucunato … Companies with BBB rated debt, the lowest tier of investment grade, have made “a very conscious choice to operate at that rating because it was the most efficient capital structure to operate with given where rates and spreads were,” Cucunato said.

Feb. 26: The majority of BBB rated companies “have the ability and are actually now showing more willingness to defend those ratings” as to avoid dipping into the high-yield market, Randall Parrish, senior high-yield portfolio manager at Voya Investment Management, said.

The natural contrarian instinct is to wonder whether the pendulum has swung too far, too fast, perhaps because of a reach for yield after the Federal Reserve’s recent pivot to pausing interest-rate increases. That doesn’t seem to be the case, judging by the change in credit spreads so far this year. They indicate the sentiment hasn’t shifted to all-out bullish on triple-B debt by any stretch.

The Pollyanna View of Credit Markets Goes Mainstream

Investors demand 66 basis points more to own triple-B bonds instead of those rated single-A, Bloomberg Barclays data show. That’s a mere 7 basis points lower than at the start of the year, which represented the widest difference since mid-2016. Similarly, securities rated double-B, just below investment grade, are significantly outperforming their triple-B brethren. The difference in spreads between the two has been cut by more than half in just two months and is closing in on the lowest level in almost 12 years. 

Simply put, both of those metrics confirm that triple-B mania hasn’t quite caught on as might be expected during a risk-on period in the bond markets. That could start to change, but probably only if further evidence supports the “debt diet” theme. S&P Global Ratings noted in a Feb. 15 report that a whopping $4.64 trillion of U.S. corporate debt it rates is scheduled to come due through 2023. Annual maturities will surpass $1 trillion in 2022 and peak at $1.1 trillion in 2023. A good chunk of that, predictably, is concentrated among the largest triple-B companies.

Even if companies sell assets or cut dividends to pay down debt, expect more deals like the one from AB InBev, which extended its obligations to avoid a maturity wall in the coming years. Indeed, Community Health Systems Inc. priced $1.58 billion of seven-year secured debt, with proceeds going toward paying off a loan due in 2021 of about the same amount. It’s rated below investment grade and has sold 14 hospitals since the start of last year.

At the heart of all credit-market investing is assessing the “willingness and ability” of an issuer to pay back its debt. As of late, it has also been about the willingness and ability to preserve — or improve — its credit rating. Bond investors didn’t see enough urgency last year, and showed their displeasure with wider yield spreads and the steepest annual loss on triple-B debt since 2008. Now that companies are turning their focus to their balance sheets, it might be time to show the “Bad Boy Bonds” some love.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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