The journey from junk: How companies get their credit rating back
Staging a comeback from having your corporate bonds slashed to "junk" status can be a long, difficult road.
Recovering from junk looks a difficult task. More than half of all ratings actions on "junk" bonds over the past three quarters have been downgrades, according to Moody's.
There is now a new generation of post-credit crisis "fallen angels" – large, previously secure companies which have been downgraded – led by Telecom Italia and ArcelorMittal.
A downgrade to "junk" is a red flag that a company may be at risk of defaulting on its debt payments, makes it more difficult for them to borrow more money, and makes a company's bonds look like a riskier investment for pension funds and asset managers that have strict mandates not to buy up high-risk assets.
"The road back to an investment grade rating is normally quite long, lasting on average three years, and is typically longer for cyclical companies," according to Stuart James, credit strategy analyst at Lloyds.
(Read more: Junk bonds areback! Thirst for yield returns)
According to James, these companies typically go through several stages before they are restored to health: running the business for cash in order to dismantle their debts; selling off non-core assets; cutting capital expenditure and dividends and then diversifying the way they raise funds so that they don't rely on credit markets.
In the meantime, higher yields on junk bonds can make them attractive to investors. This is the case at the moment, when low interest rates and low yields on safer assets like U.S. Treasurys make safer investments less profitable.
James pointed out that, since the credit crisis, many investment funds have changed their mandates so that they can hold this kind of credit for longer.
(Read more: The bond market's ticking time bomb)
"While there will still be some investors that are forced to sell because of mandate instructions, we think the majority can now either transfer the bonds to a (growing) high yield fund, apply to credit committee to hold the bonds to maturity or at the very least hold the bonds for a period of six months," he said.
This should mean that investors will be less inclined to dump junk bonds as soon as risk appetite decreases, which could help companies keep going for longer.
The appetite for junk bonds seems to have increased during this year. The SPDR Barclays High Yield Bond (JNK), a key measure of junk bonds, has reached prices not seen since the days before the collapse of Lehman Brothers. This can be attributed to unprecedented injections of cheap money into the market from Federal Reserve and European Central Bank, giving many investors extra cash to buy up junk bonds.
However, as these central bank measures begin to wind down, and the amount of money in the markets starts to dry up, riskier assets become less attractive. This May, the Barclays U.S. Corporate High Yield Index – the main index for the U.S. junk bond market – saw yields fall below 5 percent -- the first time in the index's history.
To make up for this "tapering", there has been a growth of "covenant lite" loans – instruments where the usual protections for lenders are not in place -- to companies whose rating is "junk," says Collin Martin, senior research analyst, fixed income at the Schwab Center for Financial Research.
These kind of loans may help companies regain their credit rating more quickly: but if banks have to call in non-performing loans more quickly than planned, there could still be a rocky road ahead for those companies eager to shake off their junk status.
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