Lesson from Kraft Heinz Downgrade: Bondholders Beware
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
Featuring
John Sheehan
Vice President & Portfolio Manager
Prior to joining Osterweis Capital Management in 2018, John 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.
He is a principal of the firm and a Portfolio Manager for the total return fixed income strategy.
Mr. Sheehan graduated from Georgetown University (B.A. in Economics). Mr. Sheehan holds the CFA designation.
For more information about this strategy, please send us an email or call us at (800) 700-3316.
Holdings and allocations may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities. Current and future holdings are subject to risk.
The Fund’s holdings may be viewed by clicking here.
Opinions expressed are those of the author, are subject to change at any time, are not guaranteed and should not be considered investment advice. Past performance does not guarantee future results.
Mutual fund investing involves risk. Principal loss is possible. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities.
Past performance is not a guarantee of future results. Index performance is not illustrative of fund performance. One cannot invest directly in an index. Please call (866) 236-0050 for fund performance.
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.
High-yield, or “below investment grade” bonds, include bonds with a lower credit rating than investment-grade. These bonds typically pay higher coupons as they are riskier.
A basis point is a unit that is equal to 1/100th of 1%.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality. Option-Adjusted Spread is a spread calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change.
Credit Quality weights by rating were derived from the most recent data available as determined by Standard and Poor’s. Grades are assigned to bonds by private independent rating services such as Standard & Poor’s and these grades represent their credit quality. The issues are evaluated based on such factors as the bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. Ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade. In situations where Standard & Poor’s has not issued a formal rating, the security is classified as not rated (NR). Additionally, common stocks, if any, are classified as NR.
The Osterweis Funds are available by prospectus only. The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectuses contain this and other important information about the Funds. You may obtain a summary or statutory prospectus by calling toll free at (866) 236-0050, or by visiting www.osterweis.com/statpro. Please read the prospectus carefully before investing to ensure the Fund is appropriate for your goals and risk tolerance.
Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [44150]
