Avoiding the Junkyard

kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
Quantitative Strategist
02/26/2020

There’s nothing like a Friday downgrade surprise from the ratings agencies. But what if there was a fixed income strategy that could potentially neutralize such news events while also avoiding the junkyard?

Let’s take a look at the most recent case study: Joining a ratings action by Fitch on February 14, S&P also moved to downgrade Kraft Heinz Company’s (KHC)  long-term debt to high yield (HY), or junk status. With two out of three major rating agencies now in HY, KHC became the latest “big-name” credit issuer to gain attention for losing its investment grade (IG) status.

Needless to say, prices on Kraft’s bonds sold off materially, in some cases more than 10%. Consider the price of the Kraft Heinz largest corporate bond (4 3/8% due 6/1/46), with an amount outstanding of $3 billion. After disappointing earnings and the downgrades by S&P and Fitch, the bonds fell from $101.75 on Wednesday, February 12, to $91.58 by end of day on Friday, February 14, a drop of 10.2 cents on the dollar. By Wednesday, February 19, the bonds have recovered by 3.47 cents on the dollar but still are significantly depressed.

Large KHC Bond Price (12/31/19–2/19/20)
KHC 4 3/8 6/1/46
Largest KHC Bond Price

In addition to prices falling because of investors reassessing the riskiness of Kraft’s bonds, dropping from IG to non-IG status presents technical headwinds. There are many investment mandates that restrict a fixed income portfolio to only investment-grade securities, and after a downgrade to HY, there may be forced sales that drive prices down further.

WisdomTree believes that there are trends in corporate bond fundamentals that can be used to systematically identify problematic credits. Our WisdomTree Corporate Bond Indexes use three metrics to screen out bonds: return on invested capital (ROIC), total debt to total assets, and free cash flow to debt service. All three metrics screened poorly for Kraft Heinz, and the corporate bond for Kraft was subsequently excluded from the WisdomTree Corporate Bond Indexes.

One metric that stood out was ROIC, which deteriorated significantly over the past two years. The large drop in ROIC in Q4 2018 was due to a fall in net income, an input into the ROIC ratio. Kraft Heinz had a $16 billion goodwill and intangibles write-off. This one-time write-off occurred because management believed they were overvaluing their brands.

Kraft Heinz Quarterly Net Income and Return on Invested Capital 

Kraft Heinz Quarterly Net Income and Return on Invested Capital

Conclusion

The bottom line is that this screening process enabled us to avoid having KHC in both of our strategies, the WisdomTree U.S. Short-Term Corporate Bond Fund (SFIG) and the WisdomTree U.S. Corporate Bond Fund (WFIG). That’s what we call avoiding the junkyard…

Unless otherwise stated, all data sourced is Factset as of February 19, 2020.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. While the Funds attempt to limit credit and counterparty exposure, the value of an investment in the Funds may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Funds’ portfolio investments. Please read each Fund’s prospectus for specific details regarding the Fund’s risk profile.

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About the Contributors
kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.
Quantitative Strategist
Josh Shapiro is a Quantitative Strategist for Fixed Income and Currency at WisdomTree Asset Management. Here he works on product development for new smart beta ETFs and researching existing WisdomTree strategies. Prior to joining WisdomTree, Josh held roles at OppenheimerFunds as a fixed income research analyst specializing in high yield bonds and at Intercontinental Exchange as a financial engineer building commodity pricing and risk models. Josh graduated from Pomona College with a B.A. in Mathematics and from Stony Brook University with an M.S. in Applied Mathematics and Statistics. Josh is a holder of the Charted Financial Analyst designation.