Put the real power of Asia in your portfolio Find out more

Bloomberg the Company & Its Products Bloomberg Anywhere Remote Login Bloomberg Terminal Demo Request

A $1 Trillion Powder KegThreatens the Corporate Bond

Market

By Molly Smith and Christopher CannonOctober 11, 2018 at 5:00:00 AM EDT

They were once models of financial strength—corporate giants like AT&T Inc., Bayer AGand British American Tobacco Plc.

Then came a decade of weak sales growth and rock-bottom interest rates, a dangerouscocktail that left many companies feeling like they had just one easy way to grow: byborrowing heaps of cash to buy competitors. The resulting acquisition binge left anunprecedented number of major corporations just a rung or two from junk credit ratings,bringing them closer to a designation that historically has made it much more expensive tofund daily business and harder to navigate economic downturns.

In fact, a lot of these companies might be rated junk already if not for leniency from creditraters. To avoid tipping over the edge now, they will have to deliver on lofty promises tocut costs and pay down borrowings quickly, before the easy money ends.

Bloomberg News delved into 50 of the biggest corporate acquisitions over the last fiveyears, and found:

By one key measure, more than half of the acquiring companies pushed their leverageto levels typical of junk-rated peers. But those companies, which have almost $1trillion of debt, have been allowed to maintain investment-grade ratings by Moody’sInvestors Service and S&P Global Ratings.

The vast majority of the 50 deals—valued at $1.9 trillion collectively—were financedwith debt.

This M&A-fueled leveraging of corporate balance sheets contributed to a surge in debtrated in the bottom investment-grade tier and now represents almost half of theoutstanding market, Bloomberg Barclays index data show.

“The rating agencies are giving companies too much wiggle room,” said Tom Murphy, amoney manager at Columbia Threadneedle Investments. “There’s been some pretty heroicassumptions around cost savings and debt repayments laid out by some borrowersinvolved in mergers.”

BloombergMenu Search Sign In Subscribe

Take Campbell Soup Co. The company borrowed more than $6 billion in the past year tobuy Snyder’s-Lance Inc., the maker of pretzels and other snacks. The acquisition morethan doubled the company’s debt load to nearly $10 billion, according to data compiled byBloomberg. The company now has more than 5 times as much debt as earnings beforeinterest, taxes, depreciation and amortization, a measure known as Ebitda, according toMoody’s.

While ratings firms evaluate a number of criteria, a company with leverage that high wouldbe considered junk if judged on that metric alone. For example, two Campbell Soupcompetitors, Pinnacle Foods Inc. and Lamb Weston Holdings Inc., have lower leverage andare rated below investment-grade. But Moody’s and S&P kept Campbell at investment-grade, saying they expected the merged food company to generate enough revenue to paydown its debt quickly.

A spokesman for Campbell Soup said that it expects asset sales will allow it to cut itsleverage ratio to 3 times Ebitda by 2021.

Levered UpAfter a decade-long buying spree, many companies have pushed their leverage to levels thatare typical of junk-rated borrowers in their sectors

Source: Moody’s Investors Service, Bloomberg Intelligence Notes: Broadcom’s rated issuer is Broadcom Cayman Finance Ltd. Moody’s leverage and Bloomberg Intelligence leveragemay not compare. Nutrien’s leverage is as of year-end 2017; Bayer’s leverage reflects full-year Ebitda contribution fromMonsanto. Energy sector median includes E&P, midstream oil & gas, renewables, integrated oils, oil & gas services, powerand refineries. Pipeline companies, such as those listed above, tend to have higher leverage than E&P companies.Representatives for some of the firms said this was not a fair comparison.

Current leverage2× 3× 4× 5× 6×

▹ 1.95× industry median leverage for BBB rated companiesConsumer Discretionary4.4×Newell Brands

3.5×Marriott Int’l

Technology ▹ 1.95×

2.0×Broadcom*

Materials ▹ 2.19×

4.5×LafargeHolcim3.4×Nutrien

Industrials ▹ 2.54×

3.1×Johnson Controls Int’l

Communications ▹ 2.65×

4.4×AT&T3.0×BT Group

2.8×Verizon

Health Care ▹ 2.79×

3.6×Thermo Fisher3.5×Bayer

3.4×Abbott Labs3.4×Allergan

3.0×Shire

Staples ▹ 2.82×

5.6×Keurig Dr Pepper4.6×British American Tobacco

4.2×Kraft Heinz3.7×Walgreens Boots Alliance

Energy ▹ 2.84×

5.7×Enbridge5.3×Kinder Morgan

5.2×Williams Companies5.1×Energy Transfer Partners

3.8×ONEOK

Mitigating Factors

Both Moody’s and S&P say that a company can’t be judged by its debt burden alone andthat they consider a range of factors—from a company’s size and standing in its industry tothe track record of its management. Both said their ratings historically have held up andthat they not only assess current, but future credit risks and business conditions.

“A simple ‘point in time’ snapshot of leverage fails to account for an issuer’s expecteddeleveraging trajectory in the wake of an M&A deal and can present a distorted view ofboth an issuer’s rating and the analytical process underpinning the rating,” said StephanieLeavitt, a spokeswoman for Moody’s.

Campbell’s plan to cut debt was cast into doubt shortly after the deal closed. In May, thesoup maker’s chief executive officer unexpectedly resigned, and the company forecastearnings well below analyst expectations. Facing a potential downgrade to junk, thecompany said it would pay down debt by selling assets it had spent years acquiring,including its international unit and its fresh-food business.

Dr. Pepper Snapple Group Inc. stretched the bounds when it quadrupled its debt load as itcombined with Keurig Green Mountain Inc. in an $18.7 billion deal in July. The mergedcompany, Keurig Dr. Pepper Inc., was left with around $17 billion of borrowings, whichMoody’s estimated would be 5.6 times the company’s Ebitda. That’s well above the medianratio of three times for a staples company in the highest junk tier.

Moody’s and S&P kept the company at investment grade, on the expectations that it wouldbe able to nearly halve its leverage ratio within three years with its cash flow as well as bycutting costs and eliminating duplication. But cutting debt so much relative to Ebitda isn’tusually easy, said Marie Choi, a credit analyst at TCW Group Inc., which managed around$200 billion of assets as of June 30.

“It usually takes a lot longer than two to three years to go from 6 times to 2–3 timesleverage,” Choi said.

A spokeswoman for Keurig Dr. Pepper said it has managed to rapidly cut leverage after pastdeals. After its predecessor loaded up on debt to fund a 2016 buyout by JAB Holding Co., itcut its ratio in half to 2.7 times in just two years.

The problem, says Choi, is that the credit raters are taking companies’ assumptions at facevalue instead of taking a more skeptical approach. In the Keurig deal, she said, Moody’smethodology placed nearly equal weighting on the company’s promises to pay down itsdebt as it did its ability to pay.

AT&T, Bayer

Moody’s and S&P also cut AT&T slack as it amassed the biggest corporate debt load in theworld—a whopping $190 billion—to finance purchases of Time Warner and DirecTV. Bayer’s$63 billion acquisition of Monsanto in June pushed its leverage beyond that of a typicalinvestment-grade company. And British American Tobacco was cut just two levels byMoody’s when it bought the portion of Reynolds American that it didn’t already own for$54.5 billion last year.

AT&T’s chief financial officer recently said the telecom giant will generate enough cash flowafter the Time Warner acquisition to manage its obligations. A spokesman for Bayer saidthe company is well positioned to restore its credit rating to the A tier. A representative for

British American Tobacco said that given its global presence and stable cash flow, it cantake on more debt than a regional company with the same rating.

Those corporations weren’t the only ones to keep their investment-grade ratings.Companies that completed the 50 deals reviewed by Bloomberg News were downgradedby about one notch on average, but their ratings didn’t fall as much as one would expect.Their total debt-to-Ebitda ratios are still about one step higher than companies with similarratings in the same industry, according to leverage guidelines established in June byBloomberg Intelligence analysts Joel Levington and Noel Hebert.

“There are deals out there that definitely look like late-cycle type of maneuvers,” said BrianKennedy, a portfolio manager at Loomis Sayles & Co. “Whether or not the cycle continues

Down the SpectrumCompanies’ credit ratings have dropped one level on average when funding megadeals

Source: Moody’s Investors Service, S&P Global Ratings Notes: DowDuPont’s rated issuer is Dow Chemical Co. Suntory Beverage & Food rated issuer is Suntory Holdings Ltd.

Rating change: Downgraded Upgraded No change

RatingBB BB+ BBB− BBB BBB+ A− A A+ AA− AA AA+ AAA

Teva Pharmaceutical IndustriesDell TechnologiesNXP SemiconductorsShireNewell BrandsKinder MorganEnergy Transfer PartnersBecton Dickinson and CoWilliams CompaniesONEOKKraft HeinzGLP PteBroadcomAllerganWalgreens Boots AllianceNutrienMarriott InternationalLafargeHolcimKeurig Dr PepperEnbridgeDowDuPont*BT GroupAT&TSuntory Beverage & Food*Thermo Fisher ScientificReynolds AmericanBritish American TobaccoBayerAbbott LaboratoriesVerizon CommunicationsSempra EnergyJohnson Controls Int’lAbbVieReckitt Benckiser GroupMerck KGaA, DarmstadtComcastGeneral ElectricAnheuser−Busch InBevMedtronicChubbCK Hutchison HoldingsVisaRoyal Dutch ShellPfizerBerkshire HathawayMicrosoftJohnson & Johnson

long enough for these to be deleveraging transactions remains to be seen.”

Companies have had little reason to keep their credit ratings high during a decade of easymoney, as investors worldwide shifted trillions of dollars into riskier bonds in search ofhigher yields. A company that was looking to borrow debt for seven years would pay just0.5 extra percentage point in interest annually if it were rated in the BBB tier instead of theA tier, according to Bloomberg data. That amounts to just $5 million more a year for everyadditional $1 billion the company borrows. In October 2011, that difference would havebeen almost twice as high.

The result has been a surge in debt issuance in the lowest rungs of investment-grade—thebiggest share of it driven by corporate acquisitions. There’s now about $2.47 trillion of U.S.corporate debt rated in the BBB tier, more than triple the level at the end of 2008. It nowmakes up a record 49 percent of the investment-grade bond market and has eclipsed theentire U.S. junk bond market, according to Bloomberg Barclays Index data. In 1993, forexample, just 27 percent of blue-chip corporate bonds were rated at the BBB tier.

The worry now is that, with so many of those BBB ratings dependent on the ability ofcompanies to deliver on their debt-cutting promises, any hiccup in the economy or exodusof investor cash will lead to a surge of downgrades to junk. That could lift companies’borrowing costs substantially, adding new strains to those companies. And if it were tohappen en masse, it could overwhelm the $1.3 trillion U.S. speculative-grade debt marketand potentially cause the weakest borrowers to lose access to capital.

In the last three economic downturns, between 7 and 15 percent of the investment-gradebond universe was downgraded to high yield, according to a report this month fromMorgan Stanley. But the percentage could be higher this time around because so much ofthe market is rated in the BBB tier, according to the report by strategists led by AdamRichmond. When it’s all said and done, some $1.1 trillion of investment grade debt could

The Big DowngradeMore than half of the U.S. investment-grade index now sits in the lowest ratings tier

Source: Bloomberg Barclays indices

Rating type: BBB A AA AAA Value

$5T

4

3

2

1

0

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

end up as junk, they wrote.

That’s the risk, but some analysts say that mass downgrades are unlikely. For one thing,companies on the verge of junk status usually have ways to improve their credit quality,such as selling businesses, S&P wrote in a note in July.

Corporations are also generating more cash flow relative to their debt than they havehistorically, and that money is what ultimately pays borrowings, S&P said. By itscalculations, a measure of operating cash flow is now equal to about 19 percent of debt, upfrom 17 percent in 2008. And while companies that acquire may seem to have high ratingsrelative to their debt levels, most have been good at paying down borrowings on time, andthey haven’t been downgraded during this cycle any more often than other BBBcompanies, S&P said.

Even with those caveats, big borrowers that seem solid can end up with junk ratings. InJuly 2015, Teva Pharmaceutical Industries Ltd. agreed to buy the generic-drug business ofAllergan Plc for about $40.5 billion, a deal that left the company with debt equal to morethan 4.5 times Ebitda, a level usually associated with junk ratings.

Teva’s Fall

Moody’s didn’t lower the company to speculative-grade then. Instead, over the followingmonths Moody’s cut the company by three notches to Baa3, noting that it expected thedrugmaker to cut its debt over time using its “strong and stable cash flow.” The company’sdebt levels did fall, but its earnings fell faster thanks to declines in U.S. generic drug pricesand increased competition. In January of this year, Moody’s cut the company to junk.Bonds that the company issued just two years ago at around 100 cents on the dollar nowtrade closer to 80 cents.

When a downturn comes, assumptions that seemed reasonable before may turn out tohave been overly optimistic, said Jesse Fogarty, a senior portfolio manager at InsightInvestment.

“There hasn’t been a lot of delivering on this deleveraging,” Fogarty said. “At some point,these companies that have releveraged, do they have the ability to deleverage as promised?There will be some accidents where rating agencies are less willing to make that jump frominvestment-grade to high-yield and give them the benefit of the doubt.”

With assistance from Misyrlena Egkolfopoulou.Edited by: Dan Wilchins and Shannon HarringtonPhoto: Jeff Hutchens/Getty Images

Methodology: Bloomberg News compiled 50 of the biggest corporate acquisitions announced by investment-gradecompanies since the beginning of 2013 and examined their credit ratings now and before the announcements. Onlycompleted deals were included. Financial companies were excluded, as were companies acquired by government-backedentities or those that aren't rated by Moody's and S&P. The ratings were combined into a composite number that isreflected in the graphic. It does not take ratings outlooks into account.

The companies listed in the first chart, titled “Levered Up” have two BBB-tier ratings from Moody’s and S&P. The leveragepoints for each company are the latest data from Moody’s, as measured by total debt to Ebitda. The median guidelineswere established by Bloomberg Intelligence in June and are broken out by sector and rating, also measured as total debt toEbitda.

Bloomberg gave each of the 47 companies identified a chance to comment on the data. Most either declined or didn’trespond. Those that did respond pointed to their efforts to pay down debt and their cash flow levels.

Kinder Morgan and Enbridge, both oil & gas pipeline companies, said that comparing their leverage to drillers isn’tappropriate because pipelines offer steadier cash flows, which supports higher debt levels. Kinder Morgan said its leverageis in line with its midstream peers.

Nutrien, a fertilizer maker formed when Potash Corp. of Saskatchewan Inc. combined with Agrium Inc., said it is shedding

Terms of ServiceTrademarks Privacy Policy

©2018 Bloomberg L.P. All Rights ReservedCareers Made in NYC Advertise Ad Choices Contact Us Help

equity stakes as part of its merger, which should improve its net debt position in the coming months. Pharmaceuticalcompany Merck KGaA said it follows a conservative financial policy and maintains a strong investment-grade rating.

A spokeswoman for Teva declined to comment.

Debt levels for Marriott are within the hotel operator’s targeted range as of June 30, a spokeswoman said. The company’scredit ratings are based on a number of factors, and just comparing leverage to an industry median is “very misleading”,she said.

Japan-based Suntory Beverage & Food and biotech company Shire said their respective debt repayment plans were ontrack. Dell Technologies, General Electric and Allergan referred to recent communications with investors in which eachoutlined debt reduction plans and efforts to strengthen their balance sheets.

©D

isne

y

Offer Details

Share this article: Share Tweet Post Email

The Bank of Japan's High-Wire

Act

Sept. 17, 2018

The Secret Drug Pricing

System Middlemen Use to Rake

in Millions

Sept. 11, 2018

Women in Congress Near

Breakthrough Moment in

Midterm Elections

Sept. 17, 2018

American Farmland's Massive

Shift Away From Diversity

Sept. 7, 2018

Trump Team’s Conflicts and

Scandals: An Interactive Guide

Sept. 7, 2018

The Incredible Shrinking Hedge

Fund

Sept. 11, 2018

Bankers Are Worried About

Sky-High Commercial Real

Estate Prices

Oct. 11, 2018

The Rivals Who Could Depose

Theresa May

Sept. 29, 2018