Why I'm Pouring Ketchup On Bond Ratings

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About: Keurig Dr Pepper Inc. (KDP), KHC, Includes: BBBY, BND, EXPE, HEES, TNC, USCR, VBTLX
by: Steve Shaw
Summary

Corporate bond ratings are becoming irrelevant due to their inaccuracies and many other weaknesses.

Issuers such as Kraft-Heinz and Keurig Dr. Pepper are IGINO ("Investment Grade in Name Only") and have financials worse than many high yield bond issuers.

Inaccurate ratings not only mislead investors but also unfairly penalize, or improperly reward, misrated companies.

Bond ratings are insufficient metrics, as they exclude key investment rationale factors such as interest rate risk, bond yields, bond prices, and maturities.

How is ketchup maker Kraft-Heinz (Nasdaq: KHC), with its 4.4x leverage ratio, stumbling business and accounting issues, rated investment grade?

Why is $11 billion Keurig Dr. Pepper (NYSE: KDP) rated investment grade when it has a leverage ratio of 5.4x while $60 billion grocer Albertsons has a leverage ratio of 3.6x and is rated B- by S&P?

Why does Moody's rate Expedia (Nasdaq: EXPE) as a high yield bond, Ba1, when it has a 1.8x leverage ratio and more cash than debt?

Why do all three Bed Bath & Beyond (Nasdaq: BBBY) company bonds have the same bond ratings, when its $300 million of 3.749% 8/1/24 bonds (CUSIP 075896AA8) have materially lower risk of default than its $900 million of 5.165% 8/1/44 bonds (CUSIP 075896AC4)?

Apart from these questions, we note that companies with stronger credit profiles than many investment grade bond issuers, such as US Concrete (Nasdaq: USCR), Tennant Company (NYSE: TNC), and H&E Equipment (Nasdaq: HEES), are rated below investment grade while KDP and KHC reap the many benefits of being an investment grade bond issuer.

Bond Rating Weaknesses

Many investors, especially bond index funds and ETFs, blindly follow corporate credit ratings when making bond investment decisions. This is a dangerous path given the many weaknesses associated with corporate credit ratings:

  1. Bond ratings are often inaccurate, as summarized above and discussed in further detail below;
  2. Bond ratings do not speak to the value of a bond, as they ignore the underlying bond prices and yields of bonds relative to their bond ratings;
  3. Bond ratings do not address a bond's interest rate risk or provide guidance as to which of a company's bonds could perform better based on the interest-rate environment;
  4. Bond ratings don't distinguish among an issuer's different maturities and, therefore, give the impression that a bond due 30 years from now has the same credit risk as one due in two years;
  5. Bond ratings often go years without changing even though there could be myriad buying and selling opportunities over that period of time;

  6. Thousands of corporate bonds have the same credit rating, which lumps together bond issuers with disparate credit profiles and investment rationale.

Let's face it, a corporate bond rating is a one-trick pony that doesn't even do its one trick particularly well.

Given all of these weaknesses, it's time to pour ketchup on the bond ratings of Kraft-Heinz and other misrated bond issuers.

Kraft Heinz Bond Rating

S&P and Moody's Bond Rating Scales

S&P and Moody's assign credit ratings based on numerous criteria, including a bond issuer's scale, business profile, credit ratios, financial policy, and other factors. The issuer receives a grade for each rating criterion, which is then weighted based on the bond issuer's industry (we discuss Moody's ratings methodology later in the article). As shown in the following table, the investment grade line of demarcation occurs at a rating of Baa3 / BBB-, with all bonds rated below deemed 'high-yield' or "non-investment grade."

S&P ratings scale

The layperson would likely assume that bond issuers with greater creditworthiness have higher credit ratings than issuers with lower creditworthiness. This, unfortunately, is often not the case. When looking at the below table, if I had hidden the "Rating" row at the bottom, many readers would have come to the conclusion that KHC and KDP should be the lower-rated bonds due to their higher leverage ratios (a company's debt divided by its last twelve months' EBITDA) relative to the other corporate bond issuers. Oddly, this is not the case, as it is KHC and KDP that are rated investment grade while EXPE, Albertsons, USCR, HEES, and TNC are rated high yield and are thus forced to pay higher interest expense than they should be paying.

Relationship Between Financial Metrics and Corporate Credit Ratings**

Corporate bond ratings Sources: Company SEC filings, company earnings releases, and BondSavvy calculations.

These are real-life examples of credit ratings that are simply wrong. The five issuers rated high yield by the rating agencies should be investment grade while KHC and KDP should be rated high yield. As we review Moody's ratings methodology below, we see that leverage ratios are but one of many pieces of information it takes into account when assigning ratings. While I don't believe a leverage ratio is the only worthwhile metric to review, I do believe it is an equalizer that can compare bond issuers across different industries. I believe it's superior to interest coverage, as interest coverage is a circular metric given that, if a bond issuer is rated investment grade, its interest coverage is going to be higher than if it was rated high yield since investment grade bond issuers pay lower coupons than high yield bond issuers. Leverage ratios are also superior to some of the fuzzy, qualitative metrics in Moody's methodology such as brand strength, product diversification, and pricing flexibility.

The Problems with Credit Ratings Methodology

Both Moody's and S&P apply specific methodologies to determine credit ratings. In my opinion, these methodologies often miss the forest for the trees, as the weightings of different factors can make a company's leverage ratio meaningless, as happened with KHC and KDP. The ratings methodology changes by industry, as different factors receive different weightings as shown in the below Moody's Ratings Factors. Moody's breaks down its rating factors into 'Broad Factors' and 'Subfactors.' For example, companies in the global soft beverage industry have ratings weighted 40% toward their business profile, and that 40% is comprised of five different subfactors shown on the right side of the business profile grouping:

Moody's Rating Factors: Global Soft Beverage Industry

Moody Source: Moody's Investor Service

Moody's methodology for the global soft beverage industry shows us how it got the rating for KDP so wrong. The two most important metrics from my perspective -- Retained Cash Flow / Net Debt and Debt / EBITDA -- only account for 14% of the total rating. Weighing feel-good factors such as total revenue, product diversification, brand strength and others more heavily than the most important credit metrics is misguided and results in a KDP rating that is inflated seven notches. We care about whether the company is going to have the resources to pay its interest expense and, ultimately, pay back principal on the issued bonds. Moody's and S&P ooh and aah over companies with lots of revenue, but if revenue only grew at 0.7% in 2018 as it did for KHC, scale is not going to be enough to address its bloated balance sheet.

Moody's methodology for the retail industry differs from the soft beverage industry, as there is a materially higher weighting for traditional credit metrics such as leverage and coverage. We don't have much insight on Moody's thinking on the Albertsons bonds, as Moody's had previously withdrawn its Albertsons bond ratings. That said, rating agencies such as Moody's and S&P tend to have dim views of anything touching brick & mortar retail, and this view shows through on the underrating of many brick & mortar retailers such as Albertsons.

Moody's Rating Factors: Retail Industry

Moody

Source: Moody's Investor Service.

Why Is This Important?

Due to their many shortcomings, I don't believe investors should rely primarily on corporate bond ratings to make investment decisions. It's a key reason BondSavvy makes CUSIP-level recommendations, as we not only consider a company's credit profile, but we also compare our credit analysis to the value of the bond, as determined by the bond's price and yield relative to comparable bonds.

That said, corporate credit ratings issued by Moody's and S&P have a material impact on the US corporate bond market and corporate finance in general, as they determine:

  • How much companies pay in interest: Nearly all of USCR's debt is the company's 6.375% 6/1/24 Senior Notes (CUSIP 90333LAP7), which have an annual interest expense of $38.3 million and were issued June 7, 2016. To determine USCR's potential annual interest expense savings if it was rated investment grade, I identified a KDP bond that was also issued in 2016 and has a slightly longer time until maturity: the Dr. Pepper Snapple Group 2.550% 9/15/26 bond (CUSIP 26138EAU3). Had USCR's credit rating better reflected its credit profile, it would save $23 million in annual interest expense if it issued its bonds at the 2.550% coupon rate. Such savings would free up the company to build more concrete plant facilities, get more concrete trucks on the road, and hire more workers, which would be a win for everyone.
  • Which bonds are held in different bond mutual funds and ETFs: The world's largest bond fund, Vanguard Total Bond Market Index Fund (Nasdaq: VBTLX; Nasdaq: BND) markets itself as a low-risk bond fund. Its fund prospectus even says "Credit risk should be low for the Fund because it purchases only bonds that are of investment-grade quality." It's this supposed low credit risk that the fund has used to justify its meager 1.63% average return during 2015-2018, as I previously wrote in The Vanguard Bond Fund Road to Nowhere. Ironically, this supposed low-risk fund owned 15 bonds of both Kraft-Heinz and Keurig Dr. Pepper according to the fund's December 31, 2018 annual report. These bonds, for all intents and purposes, are IGINO bonds or "Investment Grade in Name Only" bonds. As a result, VBTLX owns scores of bonds that should be rated as high yield bonds. Vanguard will hide behind the credit rating agencies in this case, but it shouldn't market a fund as having 'low credit risk' when VBTLX owns bonds that are clearly sub-investment-grade bonds.
  • Bond maturity dates: Investment grade corporate bonds often have initial bond maturities between 20 to 40 years, whereas high yield corporate bond maturities are typically 10 years and under. Some investment grade corporate bonds have even had 100-year maturities. For example, JCPenney (NYSE: JCP) issued century bonds in 1997 when it was an investment grade company. Having a longer time until maturity provides investment grade bond issuers greater financial flexibility since they don't have a near-term gun to their heads to pay back or refinance debt. It provides longer-term capital, a key advantage over high yield bond issuers.
  • Extent of financial covenants: Given the perceived higher credit quality, investment grade corporate bond issuers have few, if any, financial covenants related to their bonds. As with longer-dated maturities, the limited financial covenants provide greater operating flexibility to the issuing companies and reduce the likelihood of an event of default. For example, as noted above, JCP was an investment grade issuer when it issued bonds in 1997. These bonds came with no financial covenants and, as a result, even as the company's leverage ratio is 8x as of the most recent quarter, the company is not off-side any financial covenants.
  • How corporate bonds trade: Bond ratings determine how corporate bonds trade in the market and whether their price is impacted by changes in US Treasurys. Investment grade corporate bonds trade as a spread to their benchmark US Treasury bond whereas high yield corporate bonds trade on a dollar-price basis and are generally not impacted by changes in the benchmark US Treasury. For example, the Verizon 3.85% 11/1/42 bond (CUSIP 92343VBG8) trades off the US Treasury 2.75% 11/15/42 bond (CUSIP 912810QY7). What this means is that the yield to maturity of the Verizon bond is driven by two factors: a) the YTM of the benchmark US Treasury and b) its credit spread to the benchmark Treasury.

As shown in the Verizon 3.85% '42 bond chart below, on July 10, 2019, the bond had an ask side yield to maturity of 3.75%, which equated to a dollar price of 101.582. As we see, the benchmark US Treasury had a YTM of 2.49% and the credit spread of the Verizon bond was 1.26%. Since the Verizon bond trades off the benchmark Treasury, as the benchmark Treasury's YTM ticks up, that component of the Verizon bond's YTM would increase, thus causing the Verizon bond's price to decrease. If the bond's credit spread shrinks due to strong operating performance at Verizon, that component of the bond's YTM will fall, causing an increase in the price of the Verizon bond.

Verizon 3.85% 11/1/42 YTM Building Blocks

Verizon-bond-ytm Source: Fidelity.com "Price & Performance" screen. July 10, 2019.

High yield bonds are a horse of a different color and are credit investments that move up and down as the creditworthiness of a bond's issuing company improves or worsens. Since high yield bonds are quoted on Wall Street trading desks on a dollar-price basis, their prices do not tick up and down based on changes in their benchmark US Treasury bond.

We illustrate this concept in the following two tables, which show the price performance of the Albertsons 7.45% '29 bond (CUSIP 013104AF1) BondSavvy recommended to subscribers in September 2017 relative to its benchmark, the US Treasury 6.125% 8/15/29 (CUSIP 912810FJ2). We see that the Albertsons bond has returned 33.6% from the September 25, 2017 recommendation date through April 30, 2019 compared to a 1.7% total return for its benchmark US Treasury. During this time, the Albertsons bond increased 15 points while the benchmark US Treasury fell 7.4 points.

This example shows how the bond price of a high yield corporate bond such as Albertsons 7.45% '29 moves independent of the benchmark US Treasury. Its ability to do so is due, in large part, to its high yield bond rating.

Price Performance of Albertsons 7.45% 8/1/29 bond

Albertsons bond price history Source: FINRA market data.

Price Performance of US Treasury 6.125% 8/15/29US Treasury 081529 historical prices Source: FINRA market data

What Should Be Done?

Since corporate credit ratings impact such crucial factors from how much interest expense companies pay to how bonds trade in the open market, it's crucial the major credit rating agencies correct bond rating inaccuracies. While much time has been spent on developing ratings methodologies, a greater focus needs to be on tangible credit metrics on which companies can focus, knowing that, if they improve these credit metrics, they will be rewarded with improved ratings. Rewarding companies merely for their size and/or diversification is the wrong way to go and focuses companies on initiatives that often do not make them better companies or credits.

Moody's Says It Best

As Seeking Alpha is primarily focused on providing investment ideas and analysis to retail investors, perhaps the best way to sum up my analysis is to quote directly from a Moody's Bond Report disclaimer that reads: "MOODY’S CREDIT RATINGS AND MOODY’S PUBLICATIONS ARE NOT INTENDED FOR USE BY RETAIL INVESTORS AND IT WOULD BE RECKLESS AND INAPPROPRIATE FOR RETAIL INVESTORS TO USE MOODY’S CREDIT RATINGS OR MOODY’S PUBLICATIONS WHEN MAKING AN INVESTMENT DECISION."

If Moody's itself says use of its ratings by retail investors would be "reckless and inappropriate," then I recommend we stop being reckless and inappropriate.

Footnotes:

* For KHC, KDP, and Albertsons, revenue growth is for the most recently reported fiscal year. For all other issuers, revenue growth is for the most recently reported quarter.

** Financial data are as of the most recently reported quarter other than Kraft-Heinz and Keurig Dr. Pepper, which are based on year-end 2018 financials. The reason for this is (i) Kraft-Heinz recently restated its historical financials and issued its 10-K on June 7, 2019, and (ii) the cleanest financials for KDP were full-year 2018 pro forma financials that give full-year effect for the Keurig Green Mountain and Dr. Pepper Snapple merger, which closed July 9, 2018.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My company, BondSavvy, makes corporate bond investment recommendations, and we have, at some point, recommended certain bonds issued by Albertsons, Verizon, US Concrete, H&E Equipment, Bed Bath & Beyond, Tennant Company, Expedia, and JCPenney.