Pushing the Envelope

August 9, 2018

Pushing the Envelope Photo

The first half of 2018 has been marked by high merger and acquisition (M&A) volume in the investment-grade (IG) market, particularly in the consumer packaged goods (CPG) industry. The increase in activity has been driven by sluggish organic growth, changing consumer demands, margin pressures and the availability of cheap debt financing. M&A activity has resulted in elevated leverage, often well in excess of median credit statistics used by the market and rating agencies.

Investors use credit ratings as one input among many in assessing a company’s long-term likelihood to repay debt, and ratings often influence how bonds trade and are priced (spread above comparable Treasury rates). Rating agencies consider a company’s leverage (consolidated debt/LTM EBITDA[1]) as a factor in assessing its ability to pay down debt, or conversely, its probability of default. The median leverage ratio for investment-grade companies in the CPG space is 3x, as per Moody’s. Rating agencies tend to be patient with management teams that have established track records even if their debt ratio exceeds this threshold, so long as a credible deleveraging plan is articulated. A company’s successful execution of their financial policies is a risk bondholders always take. 

Five of the notable investment-grade M&A deals in 2018 are shown in the chart above; all have resulted in pro-forma leverage numbers that exceed the median investment-grade levels by a decent margin. Kraft Heinz, which completed their merger in July 2015, is now rumored to be interested in acquiring Campbell Soup Company, which would result in continued elevated debt levels. The rating agencies have held their IG ratings in all cases, allowing these companies time to delever. Given the positive economic backdrop, historically stable nature of these businesses and solid free-cash-flow profiles, the ratings logic makes sense. However, bondholders are exposed to any missteps given the degree to which companies are levered. With the competitive and cost challenges facing the industry, it’s not always clear how long a leash the markets or rating agencies will provide.


Key Takeaway

Due to the greater than 20% average year-to-date decline in equities for these companies,  management teams could be incentivized to divert cash to more M&A and/or share repurchases instead of debt reduction, sacrificing deleveraging along the way. As I assess the investment opportunities in this space, I am not convinced the risk/reward tradeoff is compelling at current trading levels.



[1] Note: Last twelve months (LTM); Earnings before interest, taxes, depreciation and amortization (EBITDA)

Tags: Investment grade bonds | CPG | rating agencies | Leveraged credit

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