Revolutionizing Credit Surveillance: Part One

Market problems and use cases

Recent cases of credit distress reveal the importance of promptly detecting changes in credit risk profiles even if defaults do not take place. This can support fixed income investing, market risk monitoring and Basel IV due diligence, among others.

No one-size-fits-all early warning signals

Early warning signals for credit risk changes have been available for some time. This article examines several flavours of these signals:

• Purely based on indicators from market prices
• Using credit risk fundamentals
• Derived from natural language processing (NLP) on digitised research and news.

Note: For BBB+ to BBB- rated entities, the average business risk profile was 3 (satisfactory) and financial risk profile 3 (intermediate). The yellow-shaded area is where a worse-than-average financial risk (business risk) profile was equally offset by a better business risk (financial risk) profile. We classify entities in the upper-left diagonal as those with above-average business plus financial risk profile, shaded green; and in the lower right diagonal as those with below-average business plus financial risk profile, shaded red. These classifications are proxies computed by Credit Solutions Thought Leadership from S&P Global Market Intelligence, which is independent of S&P Global Ratings.

The double-edged sword of early warning signals based on market prices

Many early warning indicators of credit risk changes rely on security prices as the primary driver. Credit default swaps mapped to the same scale as credit ratings have often signalled ratings changes.

However, the volatility of market prices may cause the early warnings to be active and inactive in consecutive months.
 

Figure 1: Distribution of Business risk profile and Financial risk profile of BBB+ to BBB- rated corporate entities, as of Sept 2024.

Fundamentals as early warning indicators

Early warning indicators on credit risk can also be rooted in fundamental analysis. Two examples are the business risk profile and the financial risk profile, which build up to corporate credit ratings.

The business risk profile is the risk and return potential for a company, its industry and country risks, and the company’s competitive position. The financial risk profile is the outcome of decisions that management makes in the context of its business risk profile and its financial risk tolerances. S&P Global Ratings maps these to a numerical score, from 1 (best) to 6 (worst), which enables their use for benchmarking. Entities with the same ratings category can have very different business and financial risk profiles. Figure 1 provides an example of the distribution for BBB+ and BBB- rated entities.

In our sample of 6,842 rated corporates, from 2014 to 2024, entities with better business plus financial risk profiles experienced net ratings upgrades over 24 months, while those worse than their peers had net ratings downgrades over the same period (figure 2).

Some observations from past cases are presented in figure 3 (better/worse relative to similarly rated peers).

Furthermore, companies that relied heavily on parent/sovereign support to attain credit ratings levels above their own fundamentals could see credit ratings downgrades if the parent’s/sovereign’s credit quality deteriorated.

In an event study using yield curve spreads over the zero-coupon treasury curve (Z-spreads), we found that bonds had not fully priced in the information from business and financial risk profiles. The Z-spreads of entities with

better-than-average business plus financial risk profiles narrowed over time, while those with worse-than-average profiles widened (figure 4).

Figure 2:  Historical ratings changes of S&P Global Ratings’ rated corporates by relative Business risk profile and Financial risk profile buckets