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Credit Markets: Ratings Firms Give Leeway To Some Big Borrowers -- WSJ

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10/21/2019 | 02:48am EDT

By Gunjan Banerji and Cezary Podkul

In August, bond-ratings firms Moody's Corp. and S&P Global Inc. predicted that Newell Brands Inc. would soon reduce its heavy debt load, allowing it to keep its coveted investment-grade bond rating.

They made the same prediction in 2018. And in 2017. And in 2016. And in 2015, when the company announced a big merger that quadrupled its debt. Yet bond ratings for the maker of Rubbermaid containers and Sharpie markers haven't budged.

When S&P and Moody's made their upbeat projections in 2018, they made an error that understated Newell's indebtedness, according to a Wall Street Journal review of the rating firms' calculations. They have since fixed their numbers, but still rate Newell investment-grade. Investors have been less forgiving, selling off the bonds and driving up their yield.

Moody's and S&P didn't dispute revising their calculations, but said the changes didn't affect their ratings.

Amid an epic corporate borrowing spree, ratings firms have given leeway to other big borrowers like Kraft Heinz Co. and Campbell Soup Co., allowing their balance sheets to swell.

"It's pretty eye-popping if you've been doing this for 20-plus years, to see how much more leverage a number of these companies can incur with the same credit rating," said Greg Haendel, a portfolio manager at Tortoise in Los Angeles overseeing about $1 billion in corporate bonds. "There's definitely some ratings inflation."

Years of rock-bottom interest rates have fueled a boom in borrowing, driving debt owed by U.S. companies excluding banks and other financial institutions to nearly $10 trillion -- up about 60% from precrisis levels. Leverage -- how much debt a company owes relative to its earnings -- hit a high in the second quarter of this year, according to JPMorgan Chase & Co. data on investment-grade bonds going back to 2004, which also excludes financial companies.

The buildup has fueled one of the most divisive debates on Wall Street: Will higher debt loads cause big losses when the economy turns? Or have low interest rates made the borrowing more manageable?

Moody's and S&P say their ratings are accurate because companies like Newell have solid, global brands and generate sufficient cash flow to pay off the bonds. "We take rating actions where appropriate in line with our methodologies," said Tom Mowat, analytical manager at S&P Global Ratings. The ratings firms also say their grades have accurately predicted defaults, which is their main purpose.

S&P and Moody's rate Newell, Kraft and Campbell Soup in their triple-B category, which is the lowest for bonds considered investment-grade. These bonds are popular with investors because they are considered unlikely to lose money. A downgrade below the lowest of the three notches in the category, triple-B-minus, would drop the companies into the junk-bond category, which could raise their borrowing costs.

The triple-B rating has exploded in the last decade, with debt outstanding more than tripling to $3.7 trillion, Intercontinental Exchange data show. These days, about 50% of all investment-grade bonds are rated triple-B, up from 38% in September 2009.

Investors are skeptical of some of the ratings. More than $100 billion worth of bonds trade with yields like junk despite their triple-B-minus ratings, pricing info from Advantage Data Inc. shows. That is despite a flood of cash into investment-grade debt. The Bloomberg Barclays U.S. Corporate Investment-Grade Index has returned 13% this year, on track for its best performance since 2009, according to FactSet.

Investors and analysts have told the Securities and Exchange Commission that they are concerned about the buildup of triple-B debt.

Last October, Adam Richmond, Morgan Stanley's then head of U.S. credit strategy, testified at an SEC hearing that if leverage were the sole criteria for ratings, many triple-B rated companies wouldn't qualify for such high grades. He warned that "downgrade activity could be heavy" once the economy inevitably weakens. The firm's analysts wrote in a September report that investment-grade companies "have not de-levered significantly and are still getting credit for assumed earnings growth, integration of acquisitions, and other 'plans' to delever."

JPMorgan raised similar concerns in a report it submitted to a bond-investor advisory committee at the SEC. In February, the committee created a new group to examine credit ratings and potentially recommend new regulations to boost oversight of the industry, according to people familiar with the group.

Moody's and S&P both say other factors they consider show less risk among triple-B rated companies. Cash flow relative to debt has improved even as leverage has increased, S&P says. Moody's analysts wrote in a January report that these borrowers are "substantially larger, more profitable and less burdened by interest expense than in 2007."

Kristalina Georgieva, the new head of the International Monetary Fund, was more cautious in a speech earlier this month. In a major downturn, she said, $19 trillion of corporate debt would be at risk of default, nearly 40% of total debt in eight major economies. "This is above the levels seen during the financial crisis," she said.

Last year, S&P upgraded Kraft, one of the biggest corporate borrowers, saying cost savings would help push leverage below four times annual earnings by late 2019. In June, S&P downgraded Kraft as the company restated past earnings but kept Kraft at the lowest rung of investment-grade, giving it another two years to meet the target. In September, S&P estimated leverage was in the "high-4x area."

"How long do you give management the benefit of the doubt?" said Lon Erickson, a portfolio manager at Thornburg Investment Management, who oversees $7 billion in corporate debt, including some Kraft bonds.

A spokesman for the company said that "Kraft Heinz remains committed to our investment-grade status." S&P raised questions about the bonds in an August report, but said it is waiting to see how a new strategy expected at the company next year will impact them.

Moody's downgraded Campbell Soup as it bought snack company Snyder's-Lance last year for $6.1 billion, including debt. About seven months after the downgrade, Moody's estimated Campbell's leverage had topped five times earnings and said it was "too high at current ratings." Moody's gave the company until July 2020 to get it below four times earnings.

A Campbell spokesman said the company is "well on our way" to meeting that target. After the company announced it would sell some businesses in August, Moody's analysts said the proceeds "should be sufficient to reduce Campbell's leverage closer to sustainable levels" for the rating.

When Keurig Green Mountain merged with Dr Pepper Snapple Group in 2018, Moody's said it could downgrade the combined company if leverage didn't fall to about four times earnings by January 2020. This year, Moody's said four times annual earnings by the end of 2020 was fine.

"If it's a strike, it's a strike. If it's a ball, it's a ball," said Joe Pimbley, a former Moody's analyst and principal of Maxwell Consulting. "Call it as you see it."

A spokeswoman for Keurig Dr Pepper said that S&P's and Moody's ratings "appropriately reflect the strength and creditworthiness of our company."

The ratings firms say they question companies' debt reduction plans. "By nature we are a pretty skeptical bunch. We like to poke holes in stories, " said Peter Abdill, who oversees Moody's ratings for consumer products companies.

One company that has been given significant leeway by ratings firms is consumer goods giant Newell Brands, which makes everything from Elmer's glue to Yankee Candles. While food companies like Kraft and Campbell produce steady earnings in good and bad economies, Newell is more cyclical, meaning it is more likely to run into trouble during a downturn.

When Newell said it would acquire rival Jarden Corp. for about $20 billion in December 2015, S&P and Moody's analysts said Newell could keep its low investment-grade rating because debt would fall from more than five times projected earnings to under four times by December 2017.

Newell had tens of millions of dollars riding on that decision. A provision tucked into an $8 billion acquisition bond sale in March 2016 said Newell would owe its investors as much as $160 million more in annual interest costs if it got downgraded into junk territory.

The provision highlights the conflict faced by the ratings firms. Investors use rating firms' research, but companies that issue bonds pay for the ratings. Moody's and S&P say they don't allow the conflict, or bond provisions like these, to influence their rating decisions.

In 2018, under pressure from activist investors, Newell announced plans to sell about a third of its businesses and buy back more than 40% of its shares, moves that could slow down deleveraging. Moody's and S&P confirmed the company's rating and predicted its leverage would fall to less than four times earnings by the end of 2018.

This past February, Newell announced that its debt was 3.5 times earnings at the end of 2018. But Newell failed to account for lost earnings from businesses it sold when it calculated the figure.

Investors were skeptical, said James Dunn of CreditSights, an independent credit research firm. He estimated Newell's actual debt load to be 5.3 times projected earnings.

Moody's and S&P's leverage estimates mirrored Newell's approach, according to a Journal review of their calculations. Moody's estimated Newell's year-end leverage at 3.8 times in a Nov. 2018 report. S&P put it at 3.9 times in a July 2018 note.

(MORE TO FOLLOW) Dow Jones Newswires

10-21-19 0247ET

Stocks mentioned in the article
ChangeLast1st jan.
MOODY'S CORPORATION 8.09% 244.7 Delayed Quote.-4.59%
NEWELL BRANDS INC. 5.27% 14.185 Delayed Quote.-29.92%
S&P GLOBAL INC. 6.72% 278.9 Delayed Quote.-4.23%
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