Who Should Worry About AT&T?

A lot has been written and said about the proposed union of AT&T Inc. and Time Warner Inc. since the merger was announced on Saturday. Little of it is flattering.

Senators Tim Kaine and Al Franken are “concerned” about whether the deal is anti-competitive. And two of Time Warner’s competitors, 21st Century Fox and Walt Disney, are encouraging the government to take a close look.

Even the merger arbitrageurs — who are in the business of gobbling up shares of merger targets — are having none of it. Time Warner’s shares are trading 18 percent below AT&T’s offer price, which implies only a 28 percent probability that the deal will get done.

One deal term that investors particularly dislike is the $40 billion bridge loan that JPMorgan and Bank of America — and eventually a syndicate of other banks — will extend to AT&T to finance part of the purchase price. Investors are asking what this mountain of new debt will do to AT&T’s credit rating? And what happens to the banks if AT&T isn’t able to issue enough new debt to pay back the loan?

My Gadfly colleagues, Lisa Abramowicz and Tara Lachapelle, also wrote a very shrewd column last week about some of the problems associated with all of the debt that is being incurred in the AT&T mega-marriage with Time Warner.

While the potentially anti-competitive aspects of the deal may create real grounds for criticizing it, I think that concerns about some of its financial metrics — and whether the new behemoth could effectively service its debt — are misplaced.

AT&T’s Chief Financial Officer John Stephens expects that AT&T’s net debt-to-Ebitda ratio will be 2.5 times one year after the merger. (The bridge loan requires AT&T to keep that ratio under 3.5 times.) That doesn’t seem troublesome to me.

For one thing, it’s not without precedent. AT&T’s net debt-to-Ebitda ratio jumped to 2.8 times most recently in 2006, but averaged just 1.6 times over the next four years. Now, as then, AT&T expects its leverage to decline after the merger.

Nor does AT&T’s post-merger leverage appear alarmingly high. There are 159 companies in the S&P 500 with a net debt-to-Ebitda ratio greater than 2.5 times. That’s nearly a third of the companies in the index.

AT&T’s leverage looks manageable by other measures, too. Its debt-to-equity ratio is 1, which is below the S&P 500’s ratio of 1.1 times. There are 200 companies in the S&P 500 that are more levered than AT&T pre-merger. In that context it’s hard to imagine AT&T as a worrisome outlier even after accounting for a $40 billion debt load.

Moody’s has all but acknowledged that AT&T’s rating will not be materially affected as a result of the new debt. Moody’s currently rates AT&T three levels above high-yield debt, and expects any potential cut to cost AT&T just one level. That means AT&T would still avoid being tossed in the junk bin and suffering the high borrowing costs associated with it.

Let’s also not lose sleep over the banks. AT&T’s $40 billion bridge loan will ultimately be spread among multiple lenders.

Yes, each lender still will likely have billions of dollars of exposure, but let’s put that in proper perspective: JPMorgan’s provision for loan losses has averaged $4 billion per year since 2010. During the heat of the financial crisis and its aftermath, those provisions soared to $21 billion, $32 billion and $16.6 billion in 2008, 2009 and 2010, respectively. Any default by AT&T will not deal a meaningful blow to Wall Street titans like JP Morgan.

Which brings me to who I really do think is at risk in this transaction: investors. Post-merger, that $40 billion of debt that AT&T takes on will ultimately wind up in investors’ portfolios. And it’s a dangerous world out there for debt investors.

Yield-starved investors have been chasing credit ever since interest rates collapsed in the wake of the financial crisis. The Bloomberg Barclays U.S. Intermediate Credit Index outperformed the Bloomberg Barclays U.S. Government Intermediate Index by 0.6 percent annually from its inception in January 1973 to December 2009. But since then, the Credit Index has outperformed the Government Index by 2 percent annually through September — more than three times as much.

As you would expect, the run-up in corporate bond prices has hammered credit spreads. The spread today between the yield-to-worst on the Credit Index and the Government Index is just 1 percent. That may not sound terrible relative to the average spread of 1.2 percent since 1973, but that spread has a tendency to spike when clouds gather around the economy or markets.

Take a look at prior occasions when credit spreads swelled. You’ll find the Nifty Fifty crash, Black Monday, the dot-com crash, the financial crisis, and the government shutdown — a who’s-who of frightful episodes.

Corporate bondholders may get burned even if things go well. A growing economy will eventually be accompanied by higher interest rates, and by extension higher yields on government bonds. At that point corporate bond yields may no longer look so enticing.

So let’s not fret over AT&T or Time Warner or their well-heeled lenders as we ponder this potential merger. With interest rates low and credit spreads tight, investors who inherit AT&T’s debt are most likely to get the short end of this deal.

Source: Bloomberg Gadfly, https://bloom.bg/2AgNPGz