On Wednesday, Alcoa's (AA) debt became the latest member of the junk-bond club after Moody's downgraded the senior unsecured ratings of Alcoa's various notes from Baa3 to Ba1. Moody's also assigned a Ba1 Corporate Family Rating, withdrew Alcoa's Prime-3 commercial paper rating, and assigned a Speculative Grade Liquidity Rating of SGL-1. Additionally, Moody's assigned a "Loss Given Default" (LGD) of 4, with a 54% projected loss in the event of default for all $8.6 billion of downgraded debt. Below is a table outlining the various projected loss ranges by LGD level.
≥ 0% and < 10%
≥ 10% and < 30%
≥ 30% and < 50%
≥ 50% and < 70%
≥ 70% and < 90%
≥ 90% and ≤ 100%
In the remainder of this article, I would like share with readers the good, the bad, and the ugly from the downgrade. But I would like to reverse the order, starting with the ugly and ending on a positive note.
In response to the downgrade, Alcoa issued a statement that included the following: "We believe Moody's decision is a greater reflection of macroeconomic conditions and the volatility of metal prices than a true statement of the financial and operating strength of Alcoa."
Alcoa seems to fail to appreciate the role that macroeconomic conditions and metals prices play in determining the "financial and operating strength" of its business. If the economy is weak and pricing in the industry in which one operates is weak, that will create challenges that are very real and must be dealt with by a company. If a company cannot adequately deal with those challenges, a debt downgrade may ensue. I know there are those investors who, in their defense of Alcoa, will say something about nobody caring what the rating agencies think and how horribly the rating agencies performed their jobs during the financial crisis. Let me remind investors that the majority of the criticism regarding appropriate ratings was not that the rating agencies rated debt too low. Rather, it was that the rating agencies rated debt too high.
I included Alcoa's statement under "the ugly" because after reading the 78 words, I got the sense that the company was in a bit of denial about what just happened. If a company makes the choice to respond to a rating action with a press release, it seems more appropriate to spend some time addressing the specific reasons for the downgrade and discussing how it is the company plans to get the old rating back.
It is true that Moody's mentioned weak economic conditions in its press release announcing the downgrade. Specifically, Moody's thought it necessary to state the following: "Chinese growth is slowing as evidenced by its first quarter 2013 GDP growth of 7.7% and more recent flash reports of further slowing while the PMI index in the US is evidencing a weakening trend and much of Europe remains in recession." Moody's also mentioned challenging aluminum prices. But dealing with a challenging pricing environment that, as Moody's puts it, appears to have "little catalyst for upward movement" is a very real concern that absolutely helps to shape a "true statement" of Alcoa's financial and operating strength. Moreover, Moody's specifically mentioned debt/EBITDA remaining elevated in 2013 and 2014 and EBIT/interest remaining below 2x during the same time period as not being appropriate for an investment grade rating. In addition, Moody's mentioned the necessity of improved volumes (in addition to prices) in order to achieve a sustainable strengthening in performance.
There most certainly is some good worth noting. First, Moody's set the rating outlook at stable. This is certainly better than having it set at negative. Second, Moody's mentioned Alcoa's "excellent liquidity and manageable near-term debt maturities." Incidentally, Alcoa also mentioned this in its press release. Third, Moody's acknowledged Alcoa's "success in reducing costs and improving productivity." Fourth, the rating was only downgraded one notch. A Ba1 rating is still the highest of all "junk bond" ratings. Fifth, the downgrade may give investors starved for yield an opportunity to purchase Alcoa's debt at even more attractive levels than it was already trading. There was some late day weakening in the longest-term notes (5.95% coupon, 2/1/2037 maturing, CUSIP 013817AK7) with the closing offer, 98.246, indicating a yield-to-worst of 6.09%. The May 29 closing yields-to-worst on other Alcoa notes included the following:
As an Alcoa bondholder myself, I am excited to see how the notes react in the days to come. Last but not least, the Alcoa downgrade is also good news for high-yield bond fund investors. Now that Alcoa's senior unsecured notes have joined the ranks of non-investment grade debt, I can imagine the managers for the iShares High Yield Corporate Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK) will be anxious to get their hands on the debt. The attractive yields (attractive is a relative term) on Alcoa's notes should be a welcome addition to a high-yield bond world with yields that, of late, are anything but "high-yield."
What will it take to move the rating again?
Regarding the potential for an upgrade back to investment grade, Moody's had this to say:
The rating could be upgraded should Alcoa achieve a sustainable debt/EBITDA ratio of at least 3.5x, a sustainable EBIT/interest ratio of at least 4x, and a sustainable (Cash flow less dividends)/debt ratio of at least 20%.
Regarding the potential for a further downgrade, Moody's stated, "The rating could be downgraded should debt protection metrics trend below current levels or liquidity contract materially." Furthermore, Moody's noted that should Alcoa introduce secured debt into the capital structure, the unsecured ratings could be adversely impacted.
What should investors do?
I am currently long the 2021 and 2027 maturing notes and plan to make no changes to my positions at this time. I would, however, consider rolling out of the 2021 maturing notes and into the 2027 notes (increasing that position size) under the right conditions. As someone who is currently long Alcoa debt and does not plan to reduce the overall size of my exposure to the company's debt, I certainly think it is worth owning in a diversified individual bond portfolio. If you are an investor who is desperately searching for yield in this low-yield environment, Alcoa's notes are definitely worth a closer look.
Additional disclosure: I am long Alcoa debt.