Rating firms look harder at corporate leverage
Companies that don’t meet their promises are increasingly likely to see ratings cut
Rating agencies are turning up the heat on companies that have not met commitments to reduce debt after making significant acquisitions by warning their ratings will be cut if they don’t deliver.
The development, which market participants say is a change in stance by the agencies, coincides with increased concern about rising leverage in the corporate bond market and a massive swell in the amount of Triple B rated debt.
“Although rating agencies have generally been lenient toward the leverage added in these transactions, recent actions suggest they may be adopting a more stringent approach, which could be a source of significant volatility,” said Barclays strategist Brad Rogoff in a note.
Brewer Anheuser-Busch InBev is the latest to come under fire after Moody’s in the past week threatened to lower its A3 rating by up to two notches unless it can provide a credible plan to reduce leverage more quickly after its SABMiller acquisition.
That follows the shock downgrade of Ford in late August when Moody’s cut the carmaker’s rating by one notch to Baa3, the lowest rung of investment grade. Rival S&P, meanwhile, cut General Electric’s rating by two rungs to BBB+ in the past week.
Those three companies combined have about US$152bn of US index-eligible debt outstanding, according to ICE BAML data.
“We’re seeing a pattern where rating agencies are starting to strengthen their resolve in holding management teams’ feet to the fire on promises they made,” said Jon Duensing, director of investment grade credit at Amundi Pioneer.
Agencies have faced criticism for giving some companies too much flexibility to reduce debt after acquisitions.
When AB InBev pushed its leverage to around six times earnings with its US$110bn acquisition of SABMiller, Moody’s and S&P took it at its word that leverage would be cut to about four times by around the two year anniversary of the deal’s October 2016 close. S&P still rates AB InBev at A-.
Fitch, the outlier, said AB InBev only warranted BBB grades in an unsolicited opinion, which it affirmed in March this year on expectations the company’s deleveraging will be slow.
To be sure, when giving companies leeway in ratings, it’s not just leverage that agencies have to consider. They also have to judge if revenues will grow and synergies will be created.
Other factors are a company’s size, profitability and financial policy, a spokesperson for Moody’s said.
“In the case of acquisitions, a company’s track record and their unique industry position are [also] a part of our analysis,” the Moody’s spokesperson said.
S&P’s spokesperson also said its ratings consider more than leverage, and noted that it downgraded ratings following major acquisitions this year that saw AT&T merge with Time Warner, Bayer with Monsanto, and Bacardi with Patron Spirits.
“Are the rating agencies lenient? Yes,” said Lale Topcuoglu, a senior fund manager and head of credit at JOHCM.
“But it’s also the market’s responsibility to do that due diligence. It’s not the rating agencies’ job to protect the investor.”
Steps have been taken so that the rating agencies do not forget mistakes made in the run-up to the financial crisis, when they supplied toxic mortgage bonds and CDOs with top Triple A ratings.
After those ratings failed to hold up, billions in fines were paid to settle claims of wrongdoing. Lawmakers also gave the US Securities & Exchange Commission more oversight powers of the agencies and their ratings criteria were overhauled.
But the sector still has sharp critics.
“The fact that we have not seen major fixed income price volatility or widespread defaults is not proof that the rating system has fixed itself,” public policy research firm Reason Foundation said in a report published in February.
“We will only know how robust credit ratings now are when the next downturn arrives.”
Regardless, some see Moody’s next move on AB InBev as a litmus test.
It has given the brewer scope to preserve its ratings if it can present a plan to cut leverage from 5.4 times now, and some analysts believe the company will try to do that by reducing shareholder dividend payouts.
The worry is that if Moody’s is lenient, other companies falling behind deleveraging targets may take that as a sign that they still have some flexibility.
“Rating agencies may feel like they have their back to the wall,” said Eddie Hebert, client portfolio manager at PPM America.
And there are risks that other downgrades could follow.
In a review of 32 M&A transactions since 2015 - financed with US$381bn of bonds - average leverage rose to four times from 2.4 times, JP Morgan analyst Eric Beinstein said in a recent report.
Leverage has only declined by 0.4 times on average in the six quarters after close.
“If the deleveraging or other financial targets which were promised are not achieved, ratings downgrades could be expected in many cases,” Beinstein wrote.
That could cause major price volatility at a time when there are already worries about the size of the Triple B bond market which accounts for about half of the US$6trn US investment-grade bond market, according to ICE BAML data.
“Moving from Single A to Triple B is not as important as moving from Triple B to high-yield in terms of market volatility,” said Jason Shoup, head of global credit strategy for Legal & General Investment Management America. *
“But it underscores the growth in Triple B that people have been paying attention to.”
* This sentence was altered to correct a typo and to update Shoup’s job title.