Though the bond and equity markets are often seen as opposites, it is perhaps better to see them as two sides of the same coin. When you buy a share, you are buying a small part of that company in hope of a share of its profits. In the case of corporate bonds, you are lending the company money for a set return.
It should come as no surprise then that a device created as a strength measure for the bond market – a company’s credit rating – can hit a firms’ share price as well. This was the case recently for Rolls Royce Holdings (LSE: RR), after it received its second credit downgrade in three months.
Blue chip or junk
The move by Standard & Poor’s (S&P) saw Rolls Royce’s credit rating downgraded to BBB-, having already been downgraded to triple B status in August, leaving it just one notch above ‘junk’ status. Fellow ratings agencies Fitch and Moody’s also downgraded its rating this year, though in both cases their ratings currently stand slightly high than that of S&P.
The move was taken after Rolls Royce announced a profit warning recently after it suffered a £800m hit because of problems with its turbine blades one the engines powering Boeing 787 Dreamliners. The company said it would suffer for several years to come, and puts the estimated cash costs between 2017 and 2023 at £2.4bn.
Once a bastion of British engineering – almost the very definition of an industrial blue chip – the company last had a credit rating of a single A-grade (the lowest level of blue chip) in 2017. These latest problems are likely to keep the company from returning to that same status for some time to come.
Cause and effect
The problem for equity holders with regards to a credit downgrade is two-fold. Firstly, the problems highlighted by the ratings agencies that impact a company’s risk of paying back debt, are just as likely to hurt its profits, revenues, and dividends.
Things like high debt levels and poor cash flow are as likely to impact its shares as its bonds, and profitability is an issue for bondholders as well. Indeed, as well as Brexit uncertainty, S&P said this downgrade came about because “We regard Rolls-Royce’s profitability as weak and volatile, and below average compared with peers in the aerospace and defence industry”.
The second issue for shareholders is that by itself, a credit downgrade makes things worse for a company. Understandably, it makes borrowing money harder and thus more expensive. Both in bond issuance and other financing facilities, a lower credit rating means lenders want a higher return for their perceived risk.
In the case of Rolls Royce, this may become an issue going forward. The large costs associated with the Trent 1000 engine problems, whose blades are degrading quicker than expected, will likely be a drain on the company’s finances for many years to come. It may well need to increase borrowing to account for this.
I should say credit ratings agencies are not always right in their assessment (think banks the day before the credit crunch), but even so, the downgrade itself is set to hurt Rolls Royce investors as well as bondholders.
