Canary in a Coal Mine?

On Feb. 14, the Kraft Heinz Co. (KHC) saw its debt downgraded by both Fitch Ratings and S&P Global Ratings. As a result, Kraft Heinz’s debt has lost its coveted investment-grade status.

As I discussed in an article for GuruFocus last week, the downgrade to high-yield – or junk bond – status was the result of the embattled American food company’s decision to maintain its dividend despite facing a host of financial and operational headwinds.

If misery loves company, Kraft Heinz should not have too long to wait. While it is the latest business to have its name added to the ignominious club of so-called fallen angels (companies that have seen their debt lose investment-grade status), it will certainly not be the last. Indeed, never before have there been so many companies with debt at risk of falling into the junk bin.

Dangerous addiction

In the years following the Great Recession in 2008, the Federal Reserve maintained an extremely dovish interest rate regime. As a result of this extended period of cheap debt, a significant swathe of Corporate America embarked on a decade-long borrowing spree. While the Fed’s brief flirtation with rate hikes in 2018 caused some corporate borrowers to sober up, the pressure proved short-lived. Last year, the Fed backtracked visibly from its hawkish stance, which in turn saw a quick end to companies’ flirtation with tapering off from borrowing. In 2019, corporate bond issuance surged to $2.1 trillion.

Cheap debt is always popular with borrowers, whether they are individuals or organizations. Thus, it is unsurprising that so many corporations have been tempted to indulge in record-setting bond issuance in recent years. Yet, while it may not be surprising, rising debt levels undoubtedly deserve investors’ close attention.

Moreover, there is another, bigger issue lurking beneath the surface of the corporate bond market: deteriorating quality of debt. Joe Rennison, a U.S. capital markets reporter for the Financial Times, highlighted the extent of the problem in a Feb. 18 article:

“Bonds on the lowest rung of the investment-grade ladder have more than doubled over the past decade, to almost $3.4tn, and now account for around half of the market, according to an index run by Ice Data Services.”

Between 2000 and 2007, 39% of investment-grade corporate debt was rated BBB. Last year, 51% of bonds were rated BBB. The Federal Reserve Bank of New York has expressed growing concern about this proliferation of BBB-rated debt a number of times in recent months. Yet, corporate bond markets have largely shrugged off such worries. So far, anyway.

Big trouble brewing

The Kraft Heinz downgrade adds $23 billion to the $1.2 trillion junk bond market. The company has also earned the dubious distinction of being the largest fallen angel in more than a decade. This has led some bond market watchers to wonder whether Kraft Heinz’s fall from the firmament is a signal of more trouble ahead.

Given the sheer quantity of corporate debt on the cusp of junk status, a wave of downgrades is not beyond possibility, especially in the event of a financial shock or recession. That, in turn, could trigger a serious selloff, as Rennison discussed on Feb. 17:

“Bond investors had been waiting for such a scenario: where big companies that rushed to borrow cheap money after the 2008 financial crisis fail to reduce their debt burdens, and are punished by the rating agencies. That fall into junk territory then forces some investors — bound by strict requirements to hold only top-quality bonds — to sell out of the company, sending prices tumbling further.”

According to UBS Group, (NYSE:UBS), as much as $90 billion of corporate debt could drop to junk status this year. In the event of a serious economic downturn, things would be far worse: The OECD now estimates that bonds worth in excess of $260 billion would fall to junk.

Apres Kraft, le deluge?

Thus far, I have painted a rather dim picture of the state of the corporate bond market. However, not all is doom and gloom. On Feb. 18, the Financial Times’ Lex column acknowledged that, among corporate bond investors, optimism remains the prevailing sentiment, despite Kraft Heinz’s recent fall from grace:

“For now, bondholders seem unfazed. Central banks are supportive on liquidity. Interest cover, operating profit as a multiple of interest payments, is relatively high historically.”

Moreover, while borrowing costs are still extremely low, many companies are showing some signs of abstemiousness and probity. A return to caution makes sense in light of the conditions in the broader economic environment. According to PwC’s survey of CEO economic sentiment, business leaders have, over the past two years, swung from historic optimism to historic pessimism. Seeing economic storm clouds gathering on the horizon may prove to be a good incentive for companies to kick their borrowing habits. The sooner they do, the better, as Lex opined:

“The longer the debt binge continues unchecked, the harder it will be to kick the habit later.”

Verdict

The dangerous fault lines running through the corporate bond market continue to grow, both in number and in severity. While bondholders have persisted thus far in their positive attitude, the darkening outlooks coming from within corporate c-suites should give them pause.

With so much corporate debt balanced on an economic knife-edge, the travails of Kraft Heinz might serve as a timely warning to bond investors.

Disclosure: No positions.

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This article first appeared on GuruFocus.

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