Alexandra Dimitrijevic: The sudden stop in the global economy, caused by these containment measures has been combined with an historical collapse in oil prices. And at the same time, a record volatility in the capital markets.

Nathan Hunt: This is the Essential Podcast from S&P Global. My name is Nathan Hunt. After 11 years of unprecedented economic expansion, easily available credit, and historically low interest rates had tempted many companies into taking on large amounts of debt to finance operations and expansion. But now, faced with the twin shocks of a virtual shutdown of the global economy due to the COVID-19 virus and the collapse in oil prices after the failure of OPEC+ negotiations, creditors are taking a hard look at who can pay and who might default on their debts.

I am joined today by Alexandra Dimitrijevic, Global Head of Research at S&P Global Ratings. Alexandra, thank you for joining me today.

Alexandra Dimitrijevic: Hello, Nathan. Thank you for inviting me.

Nathan Hunt: Just to set the stage a little bit for our listeners, where are you calling in from?

Alexandra Dimitrijevic: I'm actually based in London, and I am working from home today as probably many of those listening to this podcast.

Nathan Hunt: Okay. I want to start sort of historically. Set the stage for me a bit in terms of corporate credit. What has happened with corporate debt since the Great Financial Crisis of 2007/2008?

Alexandra Dimitrijevic: As you were saying in your introductory remarks, in the last decade since the Great Financial Crisis, we've seen an extensive monetary stimulus under the form of quantitative easing or low interest rates.

And as you were saying, this low interest rate environment has pushed investors in search of yields to turn to corporate debt markets among others. As a result of that, corporate boards up and down the rating scale, has been able to finance themselves at extremely favorable terms and conditions. So the implications in terms of corporate debt have been particularly important in two areas, which we've been flagging in our Credit Conditions Committee reports over the past two years. One is the Chinese corporate debt, which has rocketed, virtually increasing by 400% over the past 10 years, and this has been one of the important sources of funding for the Chinese economic growth over that decade. And the other area has been a significant increase in debt issued by corporate entities rated speculative grade. And that's particularly in the U.S. Just to give you an idea, speculative grade companies have accounted for roughly 90% of the new issuers in the past six years, and they now represent two thirds of the nonfinancial corporate entities rated in the U.S. So in terms of debt outstanding, just to put a figure, the leverage loan in the U.S. have increased to over $1 trillion, which is doubling over the past 10 years. And this is now roughly on par with the highest bond market.

Nathan Hunt: Just for any of our listeners who aren't familiar with some of the terminology, there's another word for speculative grade debt, isn't there?

Alexandra Dimitrijevic: So speculative grade or non-investment grade, this all gets back to, really, our rating scale. So let me remind what the credit rating is to start with. Our ratings are a forward-looking opinion about an issuer. So like a corporation or governments. So the ability and willingness to repay their debt in full and on time. And so we reflect that, a measure of credit worthiness, on that scale that goes from AAA for the highest and D for the lowest, and within that, indeed, there is an important differentiation between companies, which are rated non-investment grade or speculative grade, which is BB+ and lower, which are based on our definition and methodology more vulnerable to adverse business, financial market conditions, and those credit with investment grade ratings, so that's triple BBB- or higher, that tend to have rater resilience, greater ability to weather adverse conditions, which doesn't mean that, you know, rating changes couldn't happen at that level as well.

Nathan Hunt: Who tends to make use of these ratings that you're producing? Where are they used in the market?

Alexandra Dimitrijevic:  Ratings aim at providing transparency and reducing the asymmetry of information in the market. So they're used, for instance, by investors that use ratings as a basis for comparison on the credit quality across asset classes, geographies. It's one of the information they may use to inform their investment decisions. Some investors tend to look for the lower risk debt, such as insurers, pension funds, while other investors are searching for higher yields, and are going down the rating spectrum with entities rated B or lower, such as private equity firms. On the issuer side, why are issuers using ratings? So issuers are banks, corporations, governments. They're using ratings to access a broader source of funding on capital markets to be able to fund the capital expenditure and provide the market with transparency. Ratings are also used by intermediaries, investment banks. So ratings have compare credit risk across different types of debt securities, and they are one factor that can contribute to setting prices as it has determined one of the factors, which is credit risk.

Nathan Hunt: Okay. I just want to be clear for our listeners that your team is actually in charge of doing research within S&P Global Ratings and that you don't actually set the credit ratings. That's a separate function, a separate group. Can you tell me a bit about your team and what types of things you normally look at?

Alexandra Dimitrijevic: Right. S&P Global Ratings has a team of macro credit research experts, which I'm co-heading with our global chief economist Paul Gruenwald, and which is separate from the analytical team. Our role is to analyze the trends in the market, macro trends, credit trends across asset classes, and identify house view on the base case, which is then used by the analytical team as part of their forward looking analysis and as well identify what could be the risk to this base case. So we've put in place after the Great Financial Crisis, what we call Credit Conditions Committees, that meet at the regional level every quarter. These are a forum where our senior credit analysts and economists meets to discuss and identify these broader credit trends on risk. And of course here, given the circumstances over the past few weeks, we've been meeting multiple times and provided regular updates to our analysts on macro-economic forecasts and the trend in the credit market. Nathan, we are publishing all of these reports on our website and in particular all the reports related to the macro and crediting fact of COVID-19, including the industry research, the ratings actions, all of this is available as a special report on coronavirus.

Nathan Hunt: Speaking of that, on April 1^st, your team came out with a credit conditions report, and it was titled, “The Triple Threat.” Obviously, circumstances are moving very fast. I'm wondering if you can tell me what are the three threats that we are facing right now?

Alexandra Dimitrijevic: As we all know, unfortunately, the COVID-19 pandemic has now continued to expand globally, and while we have early signs of re-emerging in China, this pandemic is now reaching its peak in Europe and in the U.S., while it hasn't yet started to impact on emerging markets. So before talking about the key risk, I think is quite important maybe to remind what our base case is. This is a very fluid and volatile situation and it keeps evolving, but we provide regular updates on our view. At the moment, our assessment is that all of the containment measures in place for limiting the negative health impact of this virus has pushed the global economy into a recession. We've marked down now the global growth to just 0.4% this year, and this is based on the assumption that the pandemic would peak towards the middle of the year. And then that there would be a very gradual rebound in the economic activities. Just want to caveat that we are not epidemiologists at S&P Global Ratings. We are not health experts, so we have been looking at a number of government reports that indicate this immediate timeline. So the base case is really that of very steep impacts, particularly in Q2, in terms of global growth, and then very gradual recovery, more like in a U shape form. On that base case, what are the key risks that we see? One of the key risks that we see is that the pandemic isn't contained within that timeframe. That we actually see further impact later in the year, potentially a second wave in the fall, and as a result the economic implications of the pandemic could be even more severe than what we estimate at the moment.

The other risk that we see, if, you know, these containment measures fail or even absent of that, is that the demand continues to drop and impact very severely a number of sectors. Supply chains are also impacted by the situation. So I think what's really critical here is the role that is played by the fiscal and monetary policy. Both the economic and credit implications of this pandemic are going to be dependent on the resolution of the health situation. The fiscal and monetary policy responses have been very substantial in a number of countries around the world and which are really critical to breach the short-term disruption in the economy and preserve the economic fabric, preventing a large number of bankruptcies of SMEs, or avoiding a major increase in unemployment. This is really important to preserve the countries’ capacity to reemerge as rapidly as possible from the crisis once upon the pandemic recedes. So these factors are really factors that we underline in the report in terms of trying to assess the implications from a credit standpoint. As we mentioned in the reports, indeed titled “Triple Trouble: Virus, Oil and Volatility,” referring to market volatility, this sudden stop in the global economy caused by these containment measures has been combined with a historical collapse in oil prices and at the same time a record volatility in the capital market. So what we are seeing at the moment is really three factors taking place at the same time, which are putting a lot of pressure on companies, which are seeing on the one hand a drop in demand, which is leading to really a slump in their cashflow. And at the same time, they're seeing a much tighter financing condition and the longer the situation lasts—of disruption or suspension really of activity in certain sectors—the more companies might be under liquidity pressure and even absent debt maturities in the short-term, might see struggle in terms of working capital.

Nathan Hunt: I know the credit conditions report breaks out by sectors and regions. Where are you seeing sort of the most acute threats at the moment? What sectors, what regions?

Alexandra Dimitrijevic: This is really a global crisis, so no region is immune from the impact. But first and foremost, in terms of credit, the impact is in the short-term on corporate entities. Some of these sectors and industries are really the most impacted by interruption of the activity. If you look at statistics, for instance, for airlines in Europe, you see an 80% drop in airline traffic just in Q2. A statistic was released on the automobile matriculation, which were down 85% in Italy in March. We know that the social distancing has also interrupted the number of activities for restaurants, hotels, gaming. So, all of these sectors—I would say retail, hotel, gaming, media and entertainment, transportation, automotive—all of these sectors impacted by the drop of demands are the most vulnerable and the most impacted in the short term. We are seeing also interruption to across border supply chain, which might impact our companies in capital goods or in autos, obviously the collapse in oil prices is impacting the oil and gas sector, and if you want to be positive, some areas are more resilient. Utilities, for instance, or tech companies, tend to be more resistant, but it's not only, I would say, Nathan, a distinction by industry. I mean industry distinction is very important obviously, but as well, the impact is also very different by rating level.

Nathan Hunt: Alexandra, given the historical perspective we had talked about earlier, how do you see that playing out in the current crisis?

Alexandra Dimitrijevic:  Across the board we see tighter financing conditions in the current environments. Spreads have significantly increase and have reached the median of the Great Financial Crisis. Not the peak yet, but the median. But we see that investment grade rated companies tend to still have better access to liquidity—they're also benefiting from a lot of measures put in place by central banks over the past days and weeks. While for entities in the speculative grade, essentially at the moment the high yield market is closed, and some of these entities are really the most vulnerable to some of the current shocks and getting, at the same time, more difficulties to access financing. I mentioned earlier in that we had a very significant increase in a speculative grade debt particularly in the U.S. for corporates. As we enter this crisis, we have a record number, which is 30% of corporate speculative grade in the U.S., which are rated B- and lower, 20% in Europe. These are rating levels, which indicate a particularly high vulnerability to changes in business conditions, economic conditions, financing conditions. In an environment such as this one where it's more than I would say, a regular position—it's a sudden stop to the economy in a number of countries. This is going to put a lot of pressure on these weaker companies. And as a result of that, we actually expect the default rates to increase. Our estimates are that it may go above 10% in the U.S. and in the high single digits in Europe. And we expect most of the industries that we've discussed before and companies which are rated at this lower end of the rating scale to be the most impacted.

Nathan Hunt: Alexandra has S&P Global Ratings begun downgrading companies as a result of this crisis?

Alexandra Dimitrijevic: So speaking for S&P Global Ratings, indeed, these very severe conditions have led to some downgrades. As of April 1^st, we had around 330 corporate and sovereign entities downgraded globally, and another 350 currently on the negative outlook or CreditWatch with negative implication, which indicates the possible negative rating action. This represents, just to give you an idea, between 10 and 15% of the corporate ratings outstanding in Europe, the U.S., and APAC. And a little bit more than that in LatAm, where we've had as well some sovereign rating changes, particularly a downgrade of Mexico from BBB+ to BBB.

Nathan Hunt: When you look at the downgrades, are there patterns there? Is there a particular grade or area that is suffering more downgrades than others?

Alexandra Dimitrijevic: Yes. So as indicated earlier, we see the most pressure on entities at the lower end of the rating scale. And out of these rating actions, almost 70% of these rating actions to apply to entities which are rated in the speculative grade category, reflecting this greater vulnerability to this major shift in the economic conditions. Also more than half are in the U.S. and the reason is, this is where we have most of the ratings outstanding but also where we have the largest number of entities rated in a speculative-grade category. And then it's mostly, as I said, focused on the nonfinancial corporates, which as we discussed, are the most hit by in certain industries the immediate drop in demand leading to a slump. Sector-wise, the media and entertainment, retail, transportation, hotel, automotive, and then, obviously in relation to the drop in oil prices, oil and gas as well. I just thought to mention that a majority of these rating actions to date have been one notch downgrade in most of the sectors.

Nathan Hunt: I see. In some of your published reports, you have referenced volatility in capital markets. How does that affect corporate credit?

Alexandra Dimitrijevic: The market volatility affects both access to funding and the price and cost of funding. In an environment with a very high degree of uncertainty, these translate into investors requiring higher premiums to compensate for these higher risks. For weaker companies or companies with weaker ratings, even a reluctance at the moment to make capital available. So as we discussed, the high-yield market has been closed since this global expansion of the pandemic and the investment-grade market is showing signs of renewed activity on the back of central bank measures, but overall, the spreads applying across the rating scale are higher than they were prior to the crisis.

Nathan Hunt: I want to ask you about historical parallels. Does this environment look like anything else in history to you?

Alexandra Dimitrijevic: Well, the short answer is no. I don't think there are real parallels in recent history. There are lots of talks about comparing this with the Great Financial Crisis, but this is a very different type of stress. It's really starting from a health crisis then impacting onto the corporate sectors whose real economy and leading the world to this global recession, then with a potential impact on the financial market as we've discussed. I guess one of the parallels that we could look at in terms of health-shock was the pandemic of the Spanish Flu that happened after the first World War, and that affected a quarter of the population with a very severe death toll. That was over a century ago with less advanced medical technologies and certainly didn't trigger the same type of containment efforts as well, so there are limits to the parallels that we can draw here. Overall, I think maybe what's going to be critical here in how this highly uncertain situation is going to evolve or unfold—I think that first and foremost, would be the resolution of the health crisis, which is really the containment of the pandemic. At a global level, and including for emerging markets, then the impact, the lengths of the impact that this will have on the global economy, and we've noted that the impact is increasing more than proportionally, so every additional month of lockdown is having an even higher impact, even higher toll on the global economy. To end on a more positive note, for us here in Europe, and for people in the U.S. who have yet to see the peak of the pandemic, and for emerging markets where the situation is still at the beginning, we can start to look at Asia—China, Japan, Hong Kong, South Korea—and look at this situation and these countries, which are starting to re-emerge after the pandemic and try to anticipate from that maybe what the future could look like for the rest of the world.

Nathan Hunt: Alexandra, thank you for taking some time with us today.

Alexandra Dimitrijevic: Thank you, Nathan.

Nathan Hunt: Thanks for listening to the essential podcast from S&P Global. You may find links in the show notes for the articles that we've discussed today. To read all of our coverage of the coronavirus outbreak and markets, visit spglobal.com/coronavirus.