What are we looking for?
Large, indebted U.S. companies likely to be downgraded.
The screen
After the financial crisis, highly indebted companies were understandably out of vogue. Institutional investors became more risk-averse with their portfolios of corporate bonds, and issuers (companies) responded by shoring up their financial positions.
The percentage of U.S. investment-grade debt rated BBB (the lowest investment-grade rating) was less than 30 per cent in 2009, according to Goldman Sachs. That number has now climbed to 45 per cent. Furthermore, these BBB-rated companies are more indebted than in years past – the median, quarterly net-debt-to-EBITDA ratio has risen from less than 1.5 to more than two – at a time when many investors think they see a recession on the horizon. (EBITDA stands for earnings before interest, taxes, depreciation and amortization.)
Compounding this problem is the fact that interest rates are on the rise. A perfect storm of a slowing economy and rising financing costs would be particularly troublesome for already indebted companies rated BBB – one downgrade away from junk status. (Companies with a BBB-plus or BBB-minus rating are also considered one downgrade away from non-investment grade.) Once a company’s debt is deemed “junk” by rating agencies, institutional investors are restricted from holding it. The associated sell-off is bad for both debt holders and shareholders, and the fact that those companies rated BBB now represent 45 per cent of the investment-grade universe means they are probably in many investors' portfolios.
We will try to identify companies at risk of such a damaging downgrade as either sell targets for investors holding them, or, for those with more risk appetite, short-sell targets.
- We start with all companies in the United States with a market capitalization greater than US$18-billion rated BBB (or BBB-plus or BBB-minus) by Standard & Poor’s.
- Next, we identify those that have a forward quarterly net-debt-to-EBITDA ratio greater than 10, according to Refinitiv’s SmartEstimate.
- From this list of especially indebted BBB companies, we isolate those whose Refinitiv StarMine Model Implied Credit Rating is below BBB (in other words, junk). When the more-current StarMine rating is below that of the rating agency, a downgrade is four to five times more likely than an upgrade over the next year.
More about Refinitiv
Refinitiv, formerly the financial and risk business of Thomson Reuters, is one of the world’s largest providers of financial markets data and infrastructure, serving more than 40,000 institutions in more than 190 countries.
What we found
The screen yields nine companies, five of which are from the energy and utilities sectors. Outside of energy and utilities, investors will be very familiar with classic blue-chip names such as CBS Corp., Kroger Co. and General Electric Co. The largest of these, GE, also has the lowest Refinitiv Model Implied Credit Rating. Its CCC-plus rating corresponds to a 1.8-per-cent likelihood of default over the next year. High leverage is the largest contributing factor to the poor rating, and problems at GE Capital (one of the conglomerate’s divisions) could exacerbate this further in 2019. Management’s guidance is that the division’s capital deficiency will require US$3-billion, but recent analysts' estimates reach into the tens of billions of dollars.
Investors are advised to do their own research before trading in any of the securities shown here.
Hugh Smith, CFA, MBA, is an investment management specialist at Refinitiv.
Hugh Smith, CFA, MBA