While some borrowers may, as is typical, be stripped of their investment grade status in the coming weeks and months, Waxman cites several reasons for investment grade ratings having been relatively buoyant overall. Borrowing costs have shot up, but many non-financial companies have fixed-rate debt that matures well into the future. The rise in interest rates has only had a modest effect for many firms.
At the same time, the US economy has grown steadily. In turn, earnings for many investment-grade companies have been rising, and nominal growth has been robust. Earnings before interest, taxes, depreciation, and amortization (EBITDA) has increased around 5% and may climb even more next year.
“The strong growth environment and conservative allocation of cash flows led to less debt being created on balance sheets,” Waxman says. “So we’re not seeing that rapid debt creation to date, particularly over the last two years or so.”
Rising inflation may have benefited balance sheets
While there’s been much concern about the (now fading) jump in inflation since the Covid pandemic, some corporations with high-grade credit benefited from it. The impact of higher interest rates on their fixed-rate debt was diminished by higher nominal sales as prices increased.
“We like to say that corporations are nominal creatures,” Waxman says. “And so inflation actually helped a lot of companies. You had some very strong top-line growth rates.”
At the same time, some management teams reacted to the surge in interest rates by pulling back on expenditures like stock buybacks, which also helped burnish their credit metrics. “You normally only see this in a recession,” Waxman says. “Companies were just retaining cash flow.”
“We’re now trying to understand whether that starts to reverse as nominal growth slows and as rates come down,” he adds.
There are also longer-term factors at work. Before the credit crisis of 2008, corporate managements were more willing to increase leverage and allow their companies to lose their investment-grade status. Some activist investors were more open to financing strategies that resulted in higher leverage than they are now.
There are indications that those trends have reversed to some extent. “The financial crisis chastened management teams,” Waxman says. Some activist investors are more focused on operational improvements, rather than financial engineering, than they were before.
Investment grade ratings are shifting below the surface
While many US companies are retaining their investment grade rating, there’s been movement beneath the surface. A number of borrowers have fallen from A to BBB status, one tier above the riskier high-yield ratings. But very few are descending from BBB to BB, one step below investment grade.
That’s partly a result of how companies navigated a period of more sluggish economic growth, between 2013 and 2019. Management teams were more focused on “in-organic growth” — activities like stock buybacks and mergers and acquisitions, Waxman says.
“You saw companies recognize that they didn’t need to be so highly rated anymore, so long as they were somewhere in that mid BBB, or high BBB, category,” Waxman says. Companies in the telecom and beverage sectors, for example, borrowed money to fund acquisitions. Those deals increased their debt loads, but not so much that firms lost their investment grade ratings.
“It led to a dramatic growth in the BBB market,” Waxman says. The BBB rated set made up more than half of the investment grade bond market in early 2019 but has now declined to below 50%. These are often large companies that are less sensitive to fluctuations in the economy and have operational and financial flexibility.
“There was a lack of willingness to push the boundaries so far that you lost the investment grade rating,” he says.
How Fed policy and the US election will impact the market
Higher-rated companies are generally less sensitive to interest rates than companies with weaker balance sheets. For investment grade borrowers, the main implication of rate cuts by the Federal Reserve will be how that policy impacts the broader economy, Waxman says.
The US presidential election could be another near-term issue for the market. Waxman says market prices don’t appear to have adjusted for potential changes in policy from the federal government. “The market is still doing its homework. We are looking at it through a lens of taxes, trade tariffs, and regulation,” he says.
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