“Much ado” about BBBs over the past several years has resulted in “nothing” but a host of investment opportunities, in our view, as investors navigate this often misunderstood, over-feared category.
BBB Industrials are large in the context of the overall market, and fundamentals have deteriorated due to the pandemic. However, as the new credit cycle takes shape, we expect fundamentals to improve as profitability recovers and balance sheet repair is prioritized in many instances. In recent quarters, many of the large moves into the category from higher ratings have been idiosyncratic in nature (such as Boeing), self-inflicted to fund shareholder returns (in the case of Oracle) or as a result of debt used to fund M&A (in the case of Gilead). In 2020, fallen angels were offset by new entrants and many of those names, such as Kraft Heinz, are likely on the path back to investment grade.
Overall, the cyclicality of the largest BBB sectors is not as concerning as at previous times in history. For example, today’s two largest BBB issuers—Verizon and AT&T—operate in the highly cash flow-generative communications industry. Deleveraging stories are widespread in the category, but issuer-specific analysis remains highly important as not all companies will hit their targets. While CVS and AB InBev have exhibited stalled deleveraging, GE is set up to accelerate deleveraging. We expect continued opportunities to be tactical in trading BBB risk as these stories to play out.
Given that idiosyncratic situations are likely to increase in frequency in the post-pandemic era, we remain diligent in tracking corporate behavior. Companies are emerging from a highly uncertain time when liquidity was prioritized and, in many cases, are asking themselves, now what? Often, M&A has been an answer to that question. In a few instances, higher-rated entities are forgoing stronger balance sheets to operate in the BBB ratings “sweet spot.” However, most M&A activity so far has been manageable from a credit perspective, with companies being thoughtful in financing deals, using equity in many cases. We continue to think that boards and management teams who prioritize BBB ratings will continue to find value in maintaining investment grade ratings and we expect behavior in the coming quarters to be consistent with this goal. A continued nuanced and vigilant approach to the entire rating category through sector and issuer-level analysis will be an important contributor to investment performance in the dynamic post-pandemic environment.