By Coddling Shareholders, Companies Drive Down Credit Quality

May 28, 2007

The academic rankings of American students - especially in math and science - have been declining for a couple of decades now. So too, have the credit ratings of American companies.

The backslide of credit quality is nothing new, but the extent of the drop combined with ever riskier LBOs should be a wake-up call to lenders, whose historical perch at the top of the heap has been usurped by demanding shareholders.

According to part one of a new series of reports by Standard & Poor's titled "The Leveraging of America," shareholder-friendly activities are the primary driver behind American companies' deteriorating credit quality.

"They constantly have to make sure they make the shareholder happy," said Nicholas Riccio, S&P credit analyst and the author of the report. "[Shareholders] have become increasingly concerned with, not what can you do for me five years from now, but what can you do for me today?"

And this consumption with short-term gains rather than long-term objectives compels companies to make decisions that negatively affect credit and the goals of lenders.

The effects of these decisions ... well, the numbers speak for themselves. In 1980, companies S&P rated at A or above made up half of the credit spectrum. Today they make up just 11%. On the other side of the grade, B-rated companies have jumped to 42% today from 7% in 1980.

Of course, one could argue that this plethora of junk provides an ever-growing smorgasbord of opportunity for high yield loan and bond investors. Indeed, some of the biggest LBOs of late, which resulted in popular issuances on the debt market - Aramark, Harrah's, Kinder Morgan, Freescale Semiconductor - were fallen angel issuers, all now rated in the B to BB range.

But according to the S&P report, the LBOs of today might be a tad riskier than those of yesterday. Some would argue that back then RJR Nabisco, even with its 8x leverage, had a lot less business risk than many of the companies doing LBOs today. Moreover, some of today's LBOs are pushing leverage to 10x or even higher. Case in point, Alltel, which could reach 10x, according to S&P (see story, page 1).

So what's a debt investor to do? As hard as it may be to hold back when there's money to put to work, a look at the long run rather than the short (unlike the shareholders) and making a bit of noise (like the shareholders) may be the most prudent solution.

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