Corporate dealmaking that helped propel the Standard & Poor’s 500 stocks index to a record is playing out differently for debt investors, who must contend with the biggest threat to credit grades since 2009.
With borrowings to fund mergers and acquisitions accelerating amid an improving economy, the number of credit-ratings cuts linked to such deals is exceeding increases by the most since the fourth quarter of 2009, according to data from Moody’s Analytics. The firm’s credit-assessment unit lowered 96 ratings during the year ended March, while raising the rankings on 78.
The damage to balance sheets is coming amid a growing chorus of concerns that a sixth year of record-low interest rates engineered by the Federal Reserve has left bond prices overvalued and allowed borrowers to get away with financings that they wouldn’t be able to do in normal times. Valeant Pharmaceuticals International Inc. is pursuing Allergan Inc. in a takeover that may drop the Botox maker to junk status.
“Perhaps we’re being far too complacent about the outlook for credit,” John Lonski, chief financial markets economist at the Moody’s unit in New York, said by telephone April 9. “We might be shocked to find out that by 2016, we have more problems on the credit front than we currently anticipate in part because companies are now and over the near-term using leverage a little bit too aggressively.”
U.S. companies announced 3,594 deals last quarter, the most since the three months ended June 2007, according to data compiled by Bloomberg. That equates to about $360 billion in the most recent period, or more than 20 percent greater than the quarterly average over the previous four years.
At least $85 billion of junk-rated loans have been raised this year to finance acquisitions, topping 2007’s record pace, Bloomberg data show, and companies from Thermo Fisher Scientific Inc. to Nine West Holdings Inc. have faced downgrades from Moody’s following acquisitions. Automatic Data Processing Inc. was stripped of its AAA credit rating two weeks ago after the payroll-and-benefits provider said it would spin off its auto-dealer services unit.
Zimmer Holdings Inc. (ZMH) may see its Baa1 credit rating drop two levels to the cusp of junk after the maker of artificial hips and knees said today that it agreed to buy rival Biomet Inc. for $13.4 billion. The deal would require “a significant amount of debt,” Moody’s said in a statement announcing it was reviewing the rating for a downgrade.
“The wind used to be full in your sails and in support of credit, and the winds have changed to some degree,” said Thomas Urano, a money manager at Austin, Texas-based Sage Advisory Services Ltd., which oversees about $10 billion.
The risk that such transactions will impair a company’s creditworthiness is pushing Urano to favor the bonds of financial firms, which are less prone to large deals as they contend with rules meant to prevent another financial crisis.
“The regulatory environment isn’t really allowing a lot of M&A or re-levering” for financial borrowers, he said.
For much of the rest the corporate world looking to fund takeovers, though, it’s about as attractive as it’s ever been to borrow. Company-bond yields are still within half a percentage point of a record low 3.35 percent reached last year and investors are gobbling up debt in the new-issue market.
M&A transactions are poised to approach the peak levels of 2006 and 2007, Bank of America Merrill Lynch strategists led by Hans Mikkelsen wrote in an April 22 report, encouraging investors to hedge their debt holdings.
“With little upside to credit, downside protection becomes crucial for the performance of credit portfolios going forward,” the analysts wrote.
The average yield on bonds sold by the most creditworthy to the riskiest borrowers has declined to 3.75 percent from as high as 4.37 percent in September, according to Bank of America Merrill Lynch’s U.S. Corporate & High Yield Index. The gauge averaged 6.82 percent in the decade preceding the country’s last recession, which began December 2007.
By responding to the worst financial crisis since the Great Depression by cutting interest rates to about zero and then buying bonds to inject cash into the financial system, the Fed has helped set the stage.
“It definitely creates a hazard for investors in the corporate sector because you have the potential for names to get downgraded and for that to undercut some of the returns,” said Martin Fridson, the chief investment officer at Lehmann, Livian, Fridson Advisors LLC, an investment management firm based in New York and Miami.
Allergan’s $350 million of 2.8 percent notes due 2023 have dropped to a record-low 89.3 cents on the dollar to yield 4.27 percent since Laval, Quebec-based based Valeant offered to buy the business in a cash-and-stock deal valued at $45.7 billion and supported by Allergan’s largest shareholder Pershing Square Capital Management LP. The bond yield is about a percentage point higher than the 3.29 percent rate for similarly rated health-care debt, Bloomberg data show.
Moody’s, which rates Allergan A3, said April 22 that the deal imperiled its investment-grade status. Speculative-grade, or junk, bonds are ranked below Baa3 at Moody’s and lower than BBB- by S&P.
“There is very current evidence that the M&A cycle is ramping up and taking on a new and more threatening aura,” said Edward Marrinan, a macro credit strategist at RBS Securities in Stamford, Connecticut. “We are relatively long in the tooth in this market cycle.”
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