- M&A activity outstrips pre-pandemic levels as large corporations position for growth
- Record low interest rates and rebounding earnings might encourage more aggressive M&A deals that could lead to weaker credit fundamentals
Following a brief but sharp decline, 2021 merger and acquisition (M&A) volumes have surpassed pre-pandemic levels as large corporations seek to gain scale and position themselves for continued growth in years to come.
This surge in M&A activity has been boosted by record low interest rates, rising levels of CEO confidence, much-improved balance sheets and elevated cash balances. This backdrop, combined with a strong rebound in earnings, will likely motivate investment-grade corporate management teams to more aggressive uses of cash balances, which currently offer anaemic returns.
Many will likely look to make acquisitions to accelerate or prolong their growth trajectory, or to better align their businesses to the post-pandemic environment. While BBB credits are likely to continue to prioritise debt repayment in an effort to preserve investment-grade credit ratings, we believe higher-quality companies could be more willing to engage in M&A transactions that result in weaker credit fundamentals and ratings downgrades.
As pandemic-related uncertainties have eased, investment-grade credit fundamentals have largely returned to, and in some cases surpassed, pre-COVID levels. Revenue, EBITDA, profit margins, debt, and interest expense have improved. Meanwhile, after peaking in Q3 2020, cash and cash equivalents remain elevated, up approximately 20% relative to year-end 2019.
This increase in corporate cash balances and a strong rebound in earnings has motivated some corporate management teams to pursue more aggressive financial policies in recent months. For many, this has meant pursuing acquisitions to bolster growth and position themselves for a post-pandemic world. This, in turn, has helped fuel a spike in global M&A, with volumes of $4.3trn (€3.8trn) through the first nine months of 2021 already overtaking the prior all-time annual peak of $4.1trn recorded in 2007.
Meanwhile, financing conditions have rarely been this attractive. Equity valuations are high, with P/E multiples well above the five and 10-year averages. Spreads are close to post-financial crisis lows and Treasury rates are near multi-decade lows. US investment-grade gross issuance totalled $1.1trn through the first nine months of 2021, well ahead of the average pace of $960bn from 2016-19.
Yet overall issuance activity is not proportional across ratings categories. A-rated issuers have been among the most active, accounting for 47% of year-to-date total issuance, despite accounting for only 29% of the US non-financial universe by market value. Conversely, BBB-rated issuers have accounted for 44% of issuance so far in 2021, despite accounting for 62% of the investment-grade universe.
At $111bn, the M&A-related investment-grade debt issuance has been relatively muted thus far in 2021, and the $71bn of announced and still pending M&A-related issuance is moderate. However, we believe some companies are more likely than others to pursue aggressive policies vis-à-vis financials, including M&A transactions, share buybacks, and dividends at the expense of balance sheets.
Pockets of credit deterioration
While the pace of downgrades within investment grade has slowed considerably in recent quarters, pockets of credit deterioration are evident. In the first three quarters of 2021, approximately $91bn worth of single-A rated bonds were downgraded to BBB, much of which can be attributed to increased debt issuance for M&A or shareholder returns.
Among the recent downgrades are Southwest Gas and AmerisourceBergen, which both saw credit ratings lowered due to acquisitions.
Meanwhile, Baxter International’s long-term A- credit rating is currently in jeopardy, with S&P placing it on CreditWatch with negative implications, after the medical-device company said it would acquire Hill-Rom Holdings for $12.7bn.
Cost of being downgraded is low
Notably, management teams continue to appear more willing to be downgraded from A to BBB than they are to be downgraded from investment grade to high yield. While overall downgrades from investment grade to high yield have remained muted in 2021 – at only $7bn through the third quarter of the year – downgrades of non-financial investment grade totalled $292bn through the same period.
More than one-third of those debt downgrades were from A to BBB. For added perspective, about 6% of all non-financial investment-grade debt was downgraded through the first three quarters of this year, with the large majority remaining investment grade.
Underlying this pattern is that the relative cost of getting downgraded from A to BBB is quite low, while the cost of getting downgraded to below investment grade is comparably high. The spread differential between A-rated and BBB-rated corporates has declined substantially over the past few years, decreasing the benefit of a single-A rating from a funding perspective. At 37bps, the BBB-A spread differential is now at the narrowest since 2010 (see figure). As a result, the cost of higher leverage and lower ratings is quite low.
Meanwhile, the spread differential between BBB-rated and BB-rated corporates is approximately 93bps, reinforcing the value of maintaining a high-grade rating. Other benefits to remaining investment grade include maintaining access to the debt markets and the possibility that the Fed could once again purchase investment-grade corporate bonds in a severe recession or market downturn.
So while we remain cautiously optimistic on investment-grade corporate spreads overall, we expect some management teams to shift focus away from deleveraging towards more aggressive uses of capital. BBB credits are still expected to prioritise debt repayment to maintain or improve investment grade ratings – indeed, about 60% of the credit rating upgrades in Q3 were BBB-rated issuers moving up to A ratings.
Yet, the risk of M&A leading to a deterioration of fundamentals and negative credit migration among A-rated companies could become more prevalent as earnings growth begins to slow. It is a dynamic that underscores the importance of understanding management teams’ motivations and sensitivity to borrowing costs, their willingness to add leverage to the balance sheet, and their commitment to their ratings – or lack thereof.
David Del Vecchio is co-head of the US investment grade bond team at PGIM Fixed Income