Let me throw this out to the blogosphere.
There are two major reasons why a bond gets downgraded from investment grade to junk.
- The firm's operations are performing poorly.
- The firm chooses to increase leverage, for example through a LBO-type transaction.
So let's assume we have a firm currently rated A. They have $1.2 billion in operating profit and $300 million in annual debt service. The firm has $2.5 billion in expenses, $3.7 billion in revenue, and no non-debt liabilities. Let's say that if they increase leverage to 1.5x coverage, that would result in a junk rating. Obviously in real life, there is no magic interest coverage level that results in any given rating, so this is merely illustrative.
Let's consider two scenarios.
First, the company decides to increase leverage such that debt service is equal to $800 million, but operations are unchanged. That results in 1.5x coverage and a junk rating. But let's consider what's really happened here. The company took a look at its operations, and decided, by its own volition, that they could afford to be more aggressive with their financing. Sure, the margin of error is now much lower, and so the junk rating is justified, but given that the operating situation is stable, there is no imminent danger of default.
Contrast this with a second scenario, where revenue starts falling because of lackluster sales. If the company suffered a permanent decline in revenue of about 20% with no change in expenses, debt service would fall to 1.5x, and the firm loses its investment grade rating.
So what's the difference? In either case, a relatively small decline in revenue will result in net losses, and obviously continued net losses will lead to a default. But in one of the two scenarios, the company is failing to execute their basic strategy. In the other, they have simply chosen a more aggressive strategy. Which seems more dangerous to you?
So this begs the question, does the market go too far when repricing companies who are subject to sudden increases in leverage. Right now, Alltel bonds are trading cheaper than Ford Motor Credit, and I argue these two companies are good examples of each of the two scenarios described above. Ford is failing to execute. Alltel has made a strategic decision.
As many readers know, I own Alltel bonds, so I'm obviously biased. But forget about the specifics of the Alltel/Ford comparison. Conceptually, I'd rather own the LBO story than the fallen angel story. I'd always rather own the company that choose their situation than the one where the situation was trust upon them.
So I open it up to the blogosphere. Why does the market seemingly treat both these situations the same, when one sure seems more scruffy looking than the other? Why don't high yield buyers view LBO situations as superior to other firms? I'd love to hear the case for why the market acts as it does, either in the comments here or on other blogs. I've love for someone to prove me wrong here.