Our recent assessment of the M&A effects on the U.S. high yield market found that it tends to be a positive catalyst for performance. However, we see more nuanced effects—including the risk of negative rating migrations—across the investment grade corporate market. The following touches upon the momentum driving the M&A trend, the potential effects on investment-grade companies, and our resultant positioning within the sector.
Following a brief but sharp decline, 2021 M&A volumes have surpassed pre-pandemic levels as large corporations seek to gain scale and position themselves for continued growth in years to come. This surge in M&A activity has been boosted by record low interest rates, rising levels of CEO confidence, much-improved balance sheets, and elevated cash balances. That backdrop, combined with a strong rebound in earnings, will likely motivate investment grade corporate management teams to more aggressive uses of their cash balances, which currently offer anemic returns. Many will likely look to make acquisitions to accelerate or prolong their growth trajectory, or to better align their businesses to the post-pandemic environment. While BBB credits are likely to continue to prioritize debt repayment in an effort to preserve their investment-grade credit ratings, we believe higher-quality companies could be more willing to engage in M&A transactions that result in weaker credit fundamentals and ratings downgrades.
Moving Beyond the Pandemic
As the pandemic-related uncertainties eased, investment-grade credit fundamentals have largely returned to, and in some cases surpassed, pre-COVID levels. Revenue, EBITDA, profit margins, debt, and interest expense have improved. Meanwhile, after peaking in Q3 2020, cash and cash equivalents remain elevated, up approximately 20% relative to year-end 2019.1
This increase in corporate cash balances and a strong rebound in earnings has motivated some corporate management teams to pursue more aggressive financial policies in recent months. For many, this has meant pursuing acquisitions to bolster growth and position themselves for a post-pandemic world. This, in turn, has helped fuel a spike in global M&A, with volume of $4.3 trillion through the first nine months of 2021 already overtaking the prior all-time annual peak of $4.1 trillion recorded in 2007.2
Meanwhile, financing conditions have rarely been this attractive. Equity valuations are high, with P/E multiples well above the five-year and 10-year average. Spreads are near the post-financial crisis tights and Treasury rates are near multi-decade lows. U.S. investment grade gross issuance totaled $1.1 trillion through the first nine months of 2021, well ahead of the average pace of $960 billion from 2016-2019. Yet, overall issuance activity isn’t proportional across ratings categories. A-rated issuers have been among the most active, accounting for 47% of year-to-date total issuance despite accounting for only 29% of the U.S. non-financial universe by market value.3,4 Conversely, BBB-rated issuers have accounted for 44% of issuance so far in 2021 despite accounting for 62% of the investment grade universe (Figure 1).
Figure 1
A-Rated Issuance Accounted for 47% of New Issuance in 2021
At $111 billion, the M&A-related IG debt issuance has been relatively muted thus far in 2021, and the $71 billion of announced but pending M&A-related issuance is moderate. However, going forward we believe some companies are more likely than others to pursue aggressive financials polices including M&A transactions, share buybacks, and dividends at the expense of their balance sheets.
From Single-A to Triple-B
While the pace of downgrades within IG has slowed considerably in recent quarters, pockets of credit deterioration are evident. In the first three quarters of 2021, approximately $91 billion worth of single-A rated bonds were downgraded to BBB, much of which can be attributed to increased debt issuance for M&A or shareholder returns (Figure 2).5
Figure 2
Downgrades from A to BBB Jumped in 2021
Among the recent downgrades is Southwest Gas Corp. and AmeriSource Bergen, which both saw their credit ratings lowered as a result of acquisitions. In the case of Southwest Gas Corp., the company’s A- rating was lowered to BBB after completing its acquisition of Riggs Distiller & Co. in August. AmerisourceBergen’s long-term issuer rating was lowered from A- to BBB+ in June after completing its $6.5 billion acquisition of Alliance Healthcare.
Meanwhile, Baxter International’s long-term A- credit rating is currently in jeopardy, with Standard & Poor’s placing it on CreditWatch with negative implications after the medical device company said it would acquire Hill-Rom Holdings for $12.7 billion. S&P said it expects the incremental debt to increase Baxter’s adjusted leverage to about 4.1x from 1.0x-2.0x.
The Low Cost of Being Downgraded
Notably, management teams continue to appear more willing to be downgraded from A to BBB than they are to be downgraded from investment grade to high yield. While overall downgrades from investment grade to high yield have remained muted in 2021 (at only $7 billion through the third quarter of the year), downgrades of non-financial IG totaled $292 billion through the same period. More than one-third of those debt downgrades were from A to BBB. For added perspective, about 6% of all non-financial IG debt was downgraded through the first three quarters of this year, with the large majority remaining investment grade.5
Figure 3
Spread Differential Between BBBs and As at an 11-Year Low
Underlying this pattern is that the relative cost of getting downgraded from A to BBB is quite low while the cost of getting downgraded to below investment grade is comparably high. The spread differential between A-rated and BBB-rated corporates has declined substantially over the past few years, decreasing the benefit of a single-A rating from a funding perspective. At 37 bps, the BBB-A spread differential is now at the narrowest since 2010 (Figure 3). As a result, the cost of higher leverage and lower ratings is quite low. Meanwhile, the spread differential between BBB-rated and BB-rated corporates is approximately 93 bps, reinforcing the value of maintaining a high-grade rating. Other benefits to remaining investment grade include maintaining access to the debt markets and the possibility that the Fed could once again purchase investment grade corporate bonds in a severe recession or market downturn.
So, while we remain cautiously optimistic on investment grade corporate spreads overall, we expect some management teams to shift their focus away from deleveraging toward more aggressive uses of capital. BBB credits are still expected to prioritize debt repayment to maintain or improve their investment grade ratings—indeed, about 60% of the credit rating upgrades in Q3 were BBB-rated issuers moving up to A ratings.5 Yet, the risk of M&A leading to a deterioration of fundamentals and negative credit migration among A-rated companies could become more prevalent as earnings growth begins to slow. It is a dynamic that underscores the importance of understanding management teams’ motivations and sensitivity to borrowing costs, their willingness to add leverage to the balance sheet, and their commitment to their ratings—or lack thereof.
1J.P. Morgan HG Credit Fundamentals: 2Q Review, September 15, 2021.
2Reuters, “Pandemic recovery fuels deal crease as third-quarter M&A breaks all records,” September 30, 2021.
3JP Morgan US High Grade Corporate Bond Issuance Review, October 5, 2021.
4JP Morgan US HG Credit Ratings Review, July 16, 2021.
5J.P. Morgan, US HG 3Q21 Credit Rating Review, October 11, 2021.
