Published on March 3, 2020

Kraft Heinz’s recent downgrade demonstrates that bondholders can no longer assume issuers are committed to maintaining their investment grade rating, and investors who are caught off guard will pay the price.

The first significant credit downgrade of 2020 occurred on February 14, when Fitch and S&P cut the Kraft Heinz Company’s (KHC) rating from BBB- to BB+, dropping their bonds to high yield (HY) from investment grade (IG).

With roughly $23 billion of debt outstanding, Kraft Heinz was the 10th largest non-financial BBB issuer in investment grade. Following the downgrade, KHC is now the largest issuer in the high yield market on a duration weighted basis, due to their heavy concentration of debt beyond 10 years.

As we’ve discussed in the past, large BBB issuers have several levers to pull to protect their rating, including limiting share buybacks and cutting dividends. But if companies are not committed to maintaining their investment grade rating, those levers are not meaningful.

This appears to be what happened in the case of KHC. In August, Fitch noted that the company would potentially need to cut their dividend in order to protect their IG rating. But when Kraft issued earnings on February 13th they maintained their dividend level of $.40 per share. As expected, their refusal to lower their dividend factored into Fitch and S&P’s decision to downgrade KHC.

The downgrade hit holders of long dated KHC bonds particularly hard. KHC bonds due in 2049 traded down from ~$110 to $96.25 in response to the ratings action. This move has made Kraft the worst performing credit in the investment grade index in February.


Source: Bloomberg

It is also notable that a portion of the proceeds from the $1.5 billion 2049 bond (as well as from other recent large issues) was used to pay off shorter maturity debt. Kraft now only has a manageable ~$1.5 billion maturing before 2022, which means they have effectively transferred the expense of the downgrade to their existing bondholders while simultaneously minimizing their exposure to higher borrowing costs for the next couple of years.

The experience of the KHC downgrade not only reinforces our thesis that fixed income investing in 2020 will require careful credit selection, but it also reminds us that we need to be extra vigilant about assessing whether issuers are committed to keeping their investment grade ratings. Likewise, we need to monitor whether companies are more interested in supporting their bondholders or their equity investors.

Importantly, this has not changed our view of the BBB market more broadly. We still do not expect a rash of downgrades, though we do anticipate other isolated credit events may occur.

John Sheehan

Vice President & Portfolio Manager

Written by

John Sheehan

Vice President & Portfolio Manager

John Sheehan

Vice President & Portfolio Manager

John Sheehan graduated from Georgetown University (B.A. Economics). Mr. Sheehan holds the Chartered Financial Analyst designation.

Prior to joining Osterweis Capital Management in 2018, Mr. Sheehan spent more than 20 years working at Citigroup, first as Managing Director responsible for Investment Grade Syndicate in New York City, where he advised issuers on accessing funding in the corporate bond market. Later at Citigroup, he was Managing Director in charge of West Coast Investment Grade Sales in San Francisco, where he covered several of the largest U.S. investment grade credit investors.

Mr. Sheehan is a principal of the firm and a Portfolio Manager for the total return fixed income strategy.

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The ICE BofA U.S. Investment Grade Index tracks the performance of U.S. dollar denominated investment grade debt publicly issued in the U.S. domestic market.

Investment grade bonds are bonds with high and medium credit quality assigned by a rating agency. For Standard and Poor’s, investment grade bonds include BBB ratings or higher. For Moody’s, the cutoff is Baa.

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