“Food is an important part of a balanced diet.”
—Author Fran Lebowitz
Last December in the midst of a corporate credit meltdown, we penned an article on ETF.com, “Growing Risk In Dividend Focused ETFs,” where we warned how investors in dividend-focused funds could be at risk as overleveraged companies would go on a balance sheet diet lest they lose their investment-grade rating (so-called fallen-angel risk).
In the article, we posited that the Federal Reserve, having expressed early signals of a dovish pivot away from raising interest rates (a Fed “pause”), “would open a window for over-leveraged corporations to improve their balance sheets through lender-friendly capital decisions at the expense of shareholder-friendly activities.”
As stocks and corporate credit were selling off throughout the fourth quarter in 2018, the income-focused risk/reward was shifting from dividend-paying strategies to corporate credit.
Fed’s Dovish Pivot
Although we did not initially foresee the Fed pulling a 180-degree dovish turn throughout the first half of 2019, we were seeing the early onset of the Fed’s dovish pivot. That would turn Fed policy from head wind to tail wind, benefiting corporate lenders as the cost of credit for highly leveraged borrowers dropped throughout the first half of this year (Figure 1).
Figure 1: Lower Investment-Grade & High-Yield Credit Spreads Have Narrowed Throughout 2019
(For a larger view, click on the image above)
But it wasn’t just a dovish shift in Fed policy that explains the rally in lower investment-grade credit or the increased resiliency of the U.S. economy.
In a July 31, 2019 Bloomberg article, “BBB Companies Are Proving Safer Than They Seemed … ,” the authors cited research from Bank of America that “fallen angel” risk had largely dissipated as “the lowest-rated blue-company debt [proved] to be higher quality” than what was feared in 2018.
BBB-rated companies had indeed taken advantage of the window given by a newly dovish Fed to take “debt-friendly steps [such as] paying down borrowings and cutting payouts to shareholders.” BofA estimated that 12% of the investment-grade index and 20% of BBB-rated issuers (ex financials and utilities) have taken debt-friendly measures, much of them at the expense of equity shareholders.
Balance Sheet Diet
The BofA researchers viewed this level of lender-friendly activity well before the onset of a recession as “highly unusual,” suggesting that corporate America only goes on a diet when it no longer has access to the fridge. However, BofA’s observations on corporate balance sheet improvements confirmed what we had written last December:
“In a nutshell, Corporate America is going on a balance sheet ‘diet’ after having binged on share repurchases, dividend payouts, and mergers/acquisitions (M&A). If corporate finance officers stick to their New Year’s Resolution of a more disciplined capital diet (with the help of their personal trainers – the Rating Agencies), this course correction in capital allocation should favor credit holders over equity shareholders.”
We also affirmed Bloomberg Intelligence’s (BI) findings that highly leveraged companies still had time to de-lever:
“The good news is that corporate borrowers still have some time to strengthen their balance sheets while they remain profitable, assuming the global economy doesn’t fall into recession. According to BI Report, 90% of BBB-rated issuers are reporting positive operating cash flow with 50-75% of that cash flow spent on shareholder returns.”
So far in 2019, highly leveraged companies have “gotten religion,” taking proactive measures to avoid a rating downgrade now rather than later after an economic recession has already taken place.