German drugs group Bayer took a big risk in June when it issued €20 billion ($23 billion) worth of bonds to help fund its $63 billion takeover of US seed giant Monsanto. It was one of the biggest corporate bond issues of 2018 and rating agency Standard & Poor’s responded by cutting Bayer two notches to its BBB grade due to its increased debt leverage. That’s just two notches above junk status, which starts at BB+ and runs down to D.
Bayer’s move was in line with a trend. When an economic upturn nears its peak, companies often struggle to grow organically and opt for takeovers which they then finance through debt.
That’s a problem when firms that, unlike Bayer, aren’t among the most creditworthy debtors bite off more than they can chew.
The problem is compounded by an idiosyncrasy of the bond market. Corporate bonds are mainly divided between top-rated or “investment grade” debt and more risky high-interest “paper.” Many institutional investors such as pension funds and insurance companies can only buy investment grade paper (ranging from A to BBB) because their statute dictates caution. That means that if a bond is downgraded, it loses an entire category of buyers in one go and the issuer faces an abrupt rise in refinancing costs.
Former investment grade bonds downgraded to junk status are known as “fallen angels” and the number of such bonds could surge in the event of an economic downturn which would deal a major blow to global bond markets.
“Beware fallen angel risk,” warned analysts at PIMCO, one of the world’s leading fixed-income managers, in a research report, noting that the US corporate bond market had grown to $5.8 trillion from $4 trillion in the last four years. “This growth, however, has been accompanied by a steady decrease in overall credit quality. Investors should watch this trend closely.” It said BBB bonds worth $80 billion could fall to junk status this year alone. “In many cases, downgrades and even just negative outlooks from the rating agencies have an outsized effect on spreads.”
A downgrade puts a bond’s price under downward pressure, causing investors to dump the paper, which in turn boosts refinancing costs and heightens the risk of a further downgrade. It’s a vicious circle.
Brian Moriarty, an analyst at fund rating firm Morningstar, said there has been “explosive growth” in BBB bond issues. The volume of outstanding debt in this segment is as high as in all other segments of investment grade bonds, he said. It is already twice as high as the outstanding volume of junk bonds.
The problem is that the capital raised by such bond issues tends not to go into innovative products or new factories that would promise long-term returns. “Many companies use it mainly to finance dividends, share buybacks and company takeovers,” said Mr. Moriarty.
Companies are increasingly prepared to accept higher debt ratios to fund their expansion plans. Mr. Moriarty said 20 percent of firms rated as investment grade had debt amounting to more than four times their annual earnings before interest and tax.
Paul Watters, chief analyst for corporate bonds at S&P, said there was no cause for alarm as Europe’s economic outlook remained positive, and corporate debt levels weren’t overheating. Firms would only run into trouble if they could no longer refinance themselves, he said. But because many had only just borrowed a lot of fresh cash at favorable interest rates, the risks were limited right now.
Marco Stoeckle, head of corporate credit research at Commerzbank, is convinced that the market hasn’t properly priced in the risks lurking in the lower investment grade segment. “I continue to regard corporate bonds rated BBB as overvalued,” he said. He blamed the European Central Bank’s bond-buying program. “The ECB has pushed down risk premiums sharply.”
The ECB’s €2.6 trillion asset purchase scheme had driven interest rates so low that many investors accustomed to buying A-grade bonds had opted for higher-risk paper to ensure they delivered stable returns. “Now the tourists are returning to their old stomping ground which is putting BBB paper under pressure,” said Mr. Stoeckle.
He said he doesn’t expect a bond sell-off in the short term. But he added: “If we now get additional fears of a clear weakening of fundamentals, for example due to an escalating trade dispute, this would only exacerbate the existing revaluation pressures.”
Jakob Blume is a reporter with Handelsblatt’s companies and markets team. To contact the author: email@example.com