Is General Electric’s slipping credit rating a warning to all bond investors?
Witnessing a former great fall from grace is never pleasant viewing. When it is an ex-bond market darling, and you are watching its credit rating fall away from top-notch AAA to the opposite end of the investment-grade scale, it makes very painful viewing for bondholders. This has been the fate of General Electric (GE), the largest company by market capitalisation earlier this century, and its bondholders in 2018.
If GE were to fall another few notches down the ratings scale and tumble out of the investment-grade league into junk status (below BBB-), could this spell danger for the wider bond market?
We are not forecasting that GE will be downgraded to junk, otherwise known as high yield. While GE bonds have recently been downgraded to BBB+ by the three major credit-rating agencies, they have all marked the outlook as stable. Still, it’s prudent to consider the possibility given the current issues facing the business and the fact that GE bonds are trading below the rest of the BBB+ market, suggesting more ratings cuts are being priced in.
The first point to note is that GE has a lot of debt outstanding. In fact, it has more than $110 billion in outstanding bonds, with more than $25 billion due to redeem before the end of 2020 (figure 1). Given that the entire US high yield index has a face value of just over $1.2 trillion, this would boost it by nearly 10%.
Figure 1: Outstanding debts
GE's total outstanding debts are more that $110 billion; all of GE's debt represents about 10% of the total value of the US high yield market.
Source: Datastream and Rathbones.
The sheer magnitude of GE’s debt pile means that any forced selling by passive funds and other investors who are only mandated to hold investment grade bonds means that prices for all high yield bonds could suffer (yields go up) from the increase in supply relative to demand.
In fact, we think there would likely be some ‘dislocation’ in high yield markets for a few days, especially for longer-dated bonds, with minimal appetite to buy amid the wave of selling.
More expensive to service
It is also worth considering the increase in interest cost for GE if it were to issue bonds to cover those redeeming in the next two years, although the company may well look to redeem this debt without replacement, funded from other sources, such as asset sales.
The above all sounds rather negative, and indeed it would probably be a challenging period for the high yield market. However, it is worth considering that the face value of the US high yield market has shrunk by nearly $60 billion since February 2018, and is now $150 billion smaller than its recent peak in 2016 (figure 2). While some of this has been siphoned off to the growing leveraged loan market, we think it would be reasonable to expect that, given time, the high yield market would be able to cope with the increased supply, all else being equal.
We think the more important consideration is how a fall into junk status by GE might impact the wider corporate bond market. Should we take this as a warning? Are we likely to see other companies with large debt piles suffer a similar fate?
Reading too far into the fate of GE is dangerous, as some of the issues that have beset the company are certainly unique to them. For that reason, we don’t think a wider trend of downgrades to junk, and significant lasting fall in corporate bond valuations is likely.
Figure 2: A shrinking market
The face value of the US high yield market is $150 billion smaller than its recent peak in 2016.
Source: Datastream and Rathbones.
However, it may be that those companies that have undertaken ‘jumbo’ debt issuance to complete mergers and acquisitions and haven’t reduced debt as quickly as initially forecast suddenly come under heavy scrutiny. Investors (and credit rating agencies) have generally been fairly forgiving of these companies over the past couple of years, but we could see this tide turn fairly quickly. In fact, Moody’s recently placed Anheuser-Busch Inbev on watch for a downgrade to its rating (and have since downgraded its senior unsecured debt one notch), citing its slow path to paying off the debt used to buy SABMiller in late 2016. Following this warning, the company announced a halving of its dividend to accelerate its debt repayment — good news for bondholders, but at shareholders’ expense.
Investors will probably be keeping a close eye on cashflows, or any lack thereof. Poor cashflow generation has certainly been a concern in the case of GE, and justifiably so. A lack of cashflow for a highly indebted company causes concern for bond investors on two fronts — covering interest payments and repayment of capital when the bonds reach maturity. This also has spread across to equity investors, with both companies we have mentioned so far cutting their dividends substantially (in the case of GE by 92%) to focus on reducing debt.
From the bottom up
So while we don’t believe GE’s plight is a warning for the wider market (even if it were to be downgraded to high yield), it does provide a timely reminder of the value of bottom-up analysis. It certainly seems an apt time to review bond holdings in companies with large debt burdens and consider if we remain confident in the fundamentals. In fact, where this is the case, we have seen some interesting opportunities arise after valuations have become more attractive in the past couple of months.
The path of US interest rates remains a key variable to monitor when it comes to high yield markets and indeed markets as a whole. Corporations have benefited from extremely low lending rates in recent history as a result of exceptionally low official interest rates and the Federal Reserve’s (Fed’s) bond buying, or quantitative easing (QE) programme. With the Fed now a few years into its hiking cycle and reducing the huge stockpile of Treasuries it has accumulated during the QE process, borrowing rates are on the rise for corporations.
Given high-yield issuers tend to issue shorter-dated bonds (and hence have to issue bonds more frequently), they will feel the impact of rising rates before the wider market. Earnings relative to interest payments (the interest coverage ratio) will also decline unless earnings rise sufficiently to cover the higher interest costs.
We have remained sanguine about the path the Fed is likely to tread on future rate hikes, holding that structural impediments will prevent them from raising interest rates more than another two or three times in 2019. The Fed’s December meeting provided the confirmation we were looking for. Still, any further increase in interest costs will add to the problems facing highly leveraged companies, and this is what we will be watching closely in the coming year.