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The yield effect of declining credit ratings is mostly a smooth one. But then it resembles a jagged cliff. Companies in the investment-grade universe trade within a tight band of credit spreads. Businesses rated across junk status largely stay within a range as well. But according to recent research from Moody’s, “fallen angels” that tumble from high-grade to high-yield, and “rising stars” who do the opposite, experience step changes in their borrowing costs.
The average yield spread to comparable Treasury bonds soars 85 basis points, moving from Moody’s lowest investment rating Baa3 to the junk rating Ba1. The difference depends not merely upon mechanical debt-to-cash flow ratios. Credit investors typically segregate themselves as either investment-grade or high-yield investors, with their own distinct expectations about how companies manage their balance sheets. As junk bond yields have fallen to as low as five per cent, rating agencies are worried about an eventual default wave.
Until the 1980s, an active US junk bond market hardly existed. But the rise of corporate raiders and private equity showed that heavy leverage could juice up equity returns regardless of elevated default risk. Still, most large public companies prefer to keep net debt-to-ebitda below about four times.
Large corporates such as General Electric and Kraft Heinz exert great effort to persuade agencies to maintain their investment-grade status, even as their operations deteriorate. It is as much about marketing as it is about fundamental creditworthiness.
There is good reason for this. Within investment-grade, the penalty for being at the lower end of the spectrum is less onerous. From 1991 through to 2020, an A2-rated company faced an average yield spread of 138 basis points. The spread widened to just 220 at the lowest end, Baa3. Many firms within this band could still issue more debt to make acquisitions or buy back shares. But dropping one more notch through the junk threshold takes the average spread to 305 basis points, partly because of a forced sell-off by investment-grade portfolio managers and their restrictions.
Moody’s research reveals that ratings at the low end of the investment-grade range are sticky. Companies work hard to stay investment-grade, while rating agencies take care about further downgrades. Despite the fact that large, prominent companies eschew leverage, paradoxically, a thriving private equity industry embraces it.