Yesterday, bastion of British engineering Rolls-Royce Group (LSE:RR) saw its bonds lose their investment-grade rating. Standard & Poor’s officially downgraded the company’s credit rating to BB – junk status. Though the bond and equity markets are often seen as opposites, they are in fact two sides of the same coin.
Bad for one, bad for the other
Though a downgrade in credit ratings is aimed at a company’s bonds, the impact is far more wide reaching. Firstly, the reasons why a company is deemed to be less likely to pay its debts are the same reasons it will be less likely to make profit for shareholders.
In the case of Rolls-Royce, S&P cited “prolonged weak profitability” as the reason behind its decision. This, and the fact that many of the engine manufacturer’s airline clients may no longer exist after Covid-19 lockdowns.
Secondly, a softer credit rating makes it harder, or more expensive, for a company to raise money in the debt market. This inevitably means it either cannot finance things it would like, or will instead have to tap the equity market for funds. This means more shares on the market at a lower price.
Rolls-Royce said the downgrade wouldn’t trigger any short-term early debt repayments at least. Meanwhile the other major ratings agencies Fitch and Moody’s still have their ratings for Rolls-Royce above junk status – BBB+ and Baa3 respectively.
This downgrade could have an impact on the share price because of actions by institutional investors. Many big shareholders, such as pension funds, have set criteria for the kinds of shares they may hold. They may have a requirement to only hold shares in companies considered investment-grade, for example.
Simply put, some large shareholders may be forced to sell their shares in Rolls-Royce, whether they want to or not. This means we could expect to see large sales coming through in the next month or so. It will likely come in dribs and drabs to stop too much price pressure, but it will still not be good for the share price.
Triple threat
The future has three potential problems for Rolls-Royce. The obvious fact that everyone expects there to be fewer people flying will not be good. Indeed many airlines may be out of business. Needless to say this should mean cutting back on planes, and the engines they need.
Rolls-Royce predominantly focuses on engines for large, wide-body planes. These are for long haul flights. Most experts agree that when people do start flying again, short haul demand will be the most likely area to recover first.
The main problem for Rolls-Royce, however, will be the hit to its long-term servicing agreements. Its engine business is actually loss-making. It makes most of its money through service, where customers pay per hour an engine flies. During and after coronavirus, we should not expect as many hours of flying as we have seen in the past.
At its low price, Rolls Royce shares may seem like a bargain, but personally I think for now at least, the credit agencies have a point.
