Kraft downgrade could leave other issuers playing ketchup

The $1.2tn junk bond market just got about $23bn bigger. Kraft Heinz became the largest high-yield bond issuer last week, after it was downgraded by two of the big three rating agencies.

The company’s relaxed approach to its sizeable debts met with the agencies’ ire after it reported fourth-quarter earnings on Thursday. Both Fitch and S&P Global cut it from triple B minus to double B plus, pushing it below the threshold that separates investment-grade from high-yield. That makes Kraft Heinz the largest “fallen angel” in almost 15 years, according to index data from Ice Data Services.

Bond investors had been waiting for such a scenario: where big companies that rushed to borrow cheap money after the 2008 financial crisis fail to reduce their debt burdens, and are punished by the rating agencies. That fall into junk territory then forces some investors — bound by strict requirements to hold only top-quality bonds — to sell out of the company, sending prices tumbling further.

Kraft’s bond due in 2046 had been trading above par before results day but fell sharply by the end of the week, dropping from above 102 cents on the dollar to 91.5 cents.

By itself, the downgrade should not disturb the broader market. Demand for high-yield bonds remains high. Kraft’s bonds may have been hard hit because much of its debt has a maturity longer than 10 years, which is uncomfortably long for many high-yield investors. After the big fall in price, the company’s debt will probably find a home among a new group of investors more tolerant of risk.

But is the downgrade a sign of more to come? Bonds on the lowest rung of the investment-grade ladder have more than doubled over the past decade, to almost $3.4tn, and now account for around half of the market, according to an index run by Ice Data Services. Last month the Federal Reserve Bank of New York reiterated its concerns over the amount of triple B rated debt outstanding.

There are reasons to remain sanguine. Strong support from central banks has pushed out expectations of a recession in the US. And despite corporate debt levels rising to a record 47 per cent of gross domestic product, UBS analysts note that interest coverage ratios, a measure of interest bills as a percentage of operating profit, are above historical averages. Furthermore, many companies have embarked on stringent debt reduction plans, in contrast to Kraft Heinz, which still carries much of the debt taken on to finance the 2015 mega-deal that created it.

Even so, UBS expects around $80bn of debt will topple from investment grade into high yield this year, a number that could rise rapidly, if the next recession arrives sooner than expected. The bank’s analysts forecast $215bn to $235bn of fallen angel debt in the next downturn but warn that if things get really bad, that range could “almost double.”

joe.rennison@ft.com