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Beware the Single A


Single A-rated credits can potentially be riskier investments than their triple or double B-rated counterparts during a growing or recovering economy.

Watch the ratings cycle

As we edge potentially closer to the end of pandemic-related economic restrictions in the U.S., the corporate ‘ratings cycle’ is coming back into play.

Figure 1: The ratings cycle (for illustrative purposes only)

The ratings cycle

Source: Insight Investment | Illustration purposes only.

A-rated corporates in unregulated industries are often at the ‘top’ of the ratings cycle (making them less attractive) and BBB/BB corporates can often be at the ‘bottom’ of theirs.

A-rated companies are often incentivized to increase leverage

A-rated (and even high BBB) companies are often pressured by their shareholders into increasing their leverage. Consider, for example, activist investor Carl Icahn’s infamous proclamation in 2013 that, “Apple is not a bank” and should return its cash pile to shareholders.

Even though existing bondholders may be disadvantaged, increasing leverage can potentially optimize a company’s weighted average cost of capital. Today, the average credit spread (cost) resulting from a downgrade from A to BBB is only ~50 basis points (bps), around its lowest levels in over a decade (Figure 2).

Figure 2: A-rated companies face little spread penalty for a downgrade to BBB

A-rated companies face little spread penalty for a downgrade to BBB

Source: Bloomberg, BofA Merrill Lynch, April 2021

Additionally, from a corporate finance perspective, the all-in yield differential between A-rated and B-rated credit has also fallen (Figure 3). Given the decline in rates over the last year, a downgrade from A to BBB may still mean lower borrowing costs today than a year ago.

Figure 3: The all-in yield differential between A and BBB credit has also narrowed

The all-in yield differential between A and BBB credit has also narrowed

Source: Bloomberg, BofA Merrill Lynch, April 2021

A-rated companies are showing some signs of leveraging up accordingly

Net issuance is set to fall over 2021. Refinancing needs are relatively low as many companies are flush with liquidity, having raised high levels of debt in 2020 to ensure they had enough cash on hand to ride out the crisis (see Technical Tailwinds). As a result, mergers and acquisitions (M&A) is emerging as one of the remaining major drivers of new issuance in 2021 (Figure 4). Many stronger companies, for example, are considering opportunities to purchase competitors that fared less well during the pandemic.

Figure 4: M&A is on the rise

M&A is on the rise

Source: Bloomberg, April 2021

We are already seeing signs that M&A driven by A-rated corporates is on the rise. Examples of key deals that have already occurred include:

  • One computer technology corporation sold $15 billion of bonds in March to refinance debt and pay shareholders. It received a two-notch downgrade from A3 to Baa2 by Moody’s given “aggressive use of debt to finance large shareholder returns.”
  • A telecommunications conglomerate (an A-/high BBB issuer) sold $25 billion of bonds to finance spectrum purchases in the largest deal of the year so far — in our view all but giving up on its aspirations of fully returning to single-A.

We expect this trend to continue as corporates emerge from the pandemic in better shape to consider growth by acquisition.

BBB or BB companies are incentivized to reduce leverage

Unlike A-rated companies, equity holders often push lower-rated BBB or BB companies to reduce leverage, often by selling assets, raising new equity or simply by growing earnings.

This is because there is still a notable cliff between BBB and BB corporate bonds at ~160bps and another ~200bps for a downgrade to B (Figure 5). The high yield market is smaller, and less liquid, than its investment grade counterpart. High yield is also not included in the Bloomberg Barclays U.S. Aggregate Bond Index and faces less favorable insurance capital requirements. High yield companies sometimes need to include covenants to raise bonds (albeit standards have declined in recent years).

U.S. equity issuance doubled to over $300 billion in 2020, a record, as companies moved to manage cash shortfalls and contain balance sheet leverage.1

Figure 5: The penalty for a downgrade to high yield is material

The penalty for a downgrade to high yield is material

Source: Bloomberg, ICE BoA Merrill Lynch, (7-10-year BBB corporate index minus 5-8-year BB corporate index). Past performance does not guarantee future results. It is not possible to invest directly in an index.

Issuers gravitating to BBB is the “new normal”

We have seen the fastest economic cycle in history play out, from the depths of recession to the advanced stages of recovery in a single year.

The accompanying credit cycle has been equally rapid. Corporates have gone from raising defensive cash holdings at the height of the crisis to thinking about making the most of the recovery.

That leaves issuers at a fork in the ratings cycle. Higher-rated companies may potentially work more for equity holders while lower-rated firms may work more for bondholders.

We increasingly expect both will gravitate toward mid-to-high BBB ratings – a sweet spot for funding costs and balance sheet strength.

Managing A and BBB/BB debt as the economy recovers

We are mindful of A-rated companies and seek out mid-to-low BBBs and rising stars

At present, we favor mid- to low-rated BBB credit as the current sweet spot for credit allocations. For investors who desire a higher average quality, potentially blending U.S. Treasuries with BBB-rated credits may be a worthwhile option, in our opinion.

We still see some selective value in A-rated debt, but we are focused on areas still impacted by the pandemic, where we believe best-in-class players offer defensive attributes. We see value within sectors where higher ratings are often particularly desirable given the nature of business models, such as banks, insurance companies, utilities, municipalities and hospitals.

We also see selective value in crossover and high-yield names, particularly improving credit stories – such as “rising star” candidates or those that have recently completed M&A activity and are now on a de-leveraging path.

Prudent sector rotation and in-depth security selection remains essential, particularly as there will always be exceptions to the wider trend. We believe there is potential attractiveness of M&A or buybacks to management teams, as well as the company’s attractiveness as a takeover target.

In general, however, we believe gravitating toward BBB is the “new normal” for corporate credits, particularly in the industrial sectors.

CRN: 2021-0603-9235 R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit http://www.aamlive.com/.

Past performance is not indicative of future results. It is not possible to invest directly in an index.

Please note: any forecasts or opinions expressed herein are Insight Investment's own as of June 2, 2021 and subject to change without notice. Information herein may contain, include or is based upon forward-looking statements within the meaning of the federal securities laws, specifically Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include all statements, other than statements of historical fact, that address future activities, events or developments, including without limitation, business or investment strategy or measures to implement strategy, competitive strengths, goals expansion and growth of our business, plans, prospects and references to future or success. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Words such as ‘anticipate,’ ‘estimate,’ ‘expect,’ ‘project,’ ‘intend,’ ‘plan,’ ‘believe,’ and other similar words are intended to identify these forward-looking statements. Forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many such factors will be important in determining our actual future results or outcomes. Consequently, no forward-looking statement can be guaranteed. Actual results or outcomes may vary materially. Given these uncertainties, you should not place undue reliance on these forward-looking statements.

A bond rating is a grade typically given by a private independent rating service that indicates a security’s credit quality, which is intended to evaluate a bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. AAA and AA (high credit quality) and A and BBB (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations (BB, B, CCC, etc.) are considered low credit quality, and are commonly referred to as "junk bonds."


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