Chart 1

S&P Global Ratings examined 104 U.S. corporate downgrades to the 'BBB' category ('BBB+', 'BBB', and 'BBB-') from 'A-' or higher from 2010 through the first quarter of 2019. This period was unique for financing conditions in the U.S., characterized by steady economic growth, supportive monetary policies, and accommodative financing conditions.

During this period, 57% of companies downgraded to the 'BBB' category were downgraded after making decisions that led to more aggressive credit profiles.  Decisions related to M&A (including mergers, acquisitions, and asset sales) were the most common among those that resulted in downgrades to 'BBB', accounting for 45% of the downgrades, while companies that chose to increase leverage (such as to fund share buybacks, special dividends, or capital expenditure) accounted for about 12% of the downgrades.

Nonfinancials were more likely than financials to make decisions that led to downgrades.  Two-thirds of nonfinancial corporate downgrades to the 'BBB' category followed management decisions to pursue M&A and increase leverage. Low interest rates and accommodative financing conditions have influenced these decision-makers, as the costs associated with a downgrade to 'BBB' have been small. The option-adjusted credit spread of a 'BBB' category bond averaged just 69 basis points (bps) wider than that of an 'A' category issue over this period, leading many companies to make decisions that would result in lower ratings.

By contrast, most (78%) financial services downgrades to the 'BBB' category over the same period did not result from voluntary management decisions.  After the financial crisis, more financial services companies were deleveraging than were adopting more aggressive financial policies. More of the financial services downgrades over this period resulted from factors such as deterioration in competitive positions, as well as cyclical or structural declines within industries. Other reasons for the downgrades include revisions to S&P Global Ratings' criteria, regulatory changes, and shortfalls in either corporate governance or risk management.

For more information on how these rating actions were categorized, and for details on the rating actions that were included in this study, please see the appendix.

M&A-Related Management Decisions Led To Most Of The Nonfinancial Downgrades

Among nonfinancial companies, the leading reason for downgrades to the 'BBB' category since 2010 has been M&A, which accounted for 43 downgrades and more than $300 billion in debt that was affected by the downgrades (see chart 2). The largest M&A-related downgrades were for Verizon Communications Inc. (following its announced acquisition of Vodafone AG's stake in Verizon Wireless in 2013) and United Technologies Corp. (following its announced acquisition of Rockwell Collins in 2018), which together accounted for nearly a third of the debt that was downgraded for M&A-related reasons. Both issuers are currently rated 'BBB+'. Verizon is assigned a positive outlook, and the rating on United Technologies is on CreditWatch with positive implications, reflecting the potential for these issuers to be upgraded back to the 'A' category in 2020.

Chart 2

While strategic pressure or a need to strengthen business positions may be driving factors behind M&A, all of the currently rated nonfinancial issuers that were downgraded to the 'BBB' category due to M&A have maintained investment-grade ratings ('BBB-' or higher). This indicates a degree of ratings stability following the initial post-M&A downgrade, as companies generally reduced leverage over time, maintained or improved cash flow generation, and defended their competitive positions. For example, nonfinancial issuers that were downgraded to 'BBB' because of M&A prior to 2018 had median adjusted leverage of about 2.6x as of the last filing date--only modestly higher than the overall 'BBB' category average of 2.2x for all nonfinancial corporates (excluding regulated utilities).

About 14% of the nonfinancial corporate downgrades during the study period resulted from companies choosing more aggressive financial policies, often supporting debt-financed dividends or share buybacks. The largest of these downgrades was for AT&T Inc., which was downgraded to 'BBB+' on Feb. 2, 2015, after it announced an increase in its planned leverage target to fund growth initiatives, acquisition activity, and shareholder returns.

By sector, utilities, consumer products, and health care had the highest numbers of companies that were downgraded for reasons related to M&A or financial policy decisions. These three sectors generally demonstrate lower cyclicality, and utilities can tolerate higher debt loads at a given rating level due to the stability and visibility of cash flows and leveragability of hard assets.

Chart 3

Few Financial Services Companies Were Willing To Accept Higher Leverage After The Financial Crisis

Over the past 10 years, fewer financial services companies than nonfinancial companies were downgraded after management made decisions that weakened credit quality. After the financial crisis, financial services industries have largely pursued lower leverage targets, rather than increasing leverage.

Of the 23 financial services downgrades in this period, just five resulted from voluntary management decisions. Most of these downgrades were M&A-related, while one company, American International Group Inc., was downgraded as a result of its financial policy.

Just four of the financial services downgrades accounted for most of the affected debt (see chart 4). These four bank holding companies--Citigroup Inc., Bank of America, Goldman Sachs, and Morgan Stanley--were downgraded based on the removal of extraordinary government support to the U.S. banking system, reflecting the progress the banks had made in putting in place a viable U.S. resolution plan. At the time of the downgrades, these banks had more than $700 billion in associated debt. For the purpose of this report, we classified these four downgrades in the category of "regulatory changes," which accounts for most of the financial services debt that was downgraded to the 'BBB' category in this period.

Chart 4

The largest number of financial services downgrades (nine) were associated with a weakening competitive position or increasing industry risk. These included regional banks BOK Financial Corp. and Comerica Inc., which were downgraded in 2016 as asset quality in their large energy portfolios deteriorated amid falling energy prices.

Another company, Western Union Co., was downgraded to 'BBB+' on Nov. 9, 2012, as the global market for money transfer became increasingly competitive. Although Western Union was subsequently downgraded by an additional notch on March 4, 2014, as rising compliance costs and money-transfer price reductions put pressure on margins, the company currently remains rated 'BBB'.

More Companies Were Upgraded Back To 'A' Than Downgraded To Spec Grade

Of the U.S. companies downgraded to the 'BBB' category since 2010, more have been upgraded back to the 'A' category than downgraded to speculative grade ('BB+' or lower).  About 12% were upgraded back to the 'A' category, 8% are currently speculative grade, and 13% are no longer rated (see chart 5). All but one of the issuers that are no longer rated were investment grade at the time the rating was withdrawn.

Chart 5

Meanwhile, 67% remain in the 'BBB' category as of July 15, 2019.  Only 7% are currently rated 'BBB-', the rating cohort most susceptible to becoming fallen angels (issuers downgraded to speculative grade from investment grade). All of the issuers that were downgraded to speculative grade were nonfinancial companies, while all of the financial services issuers either remained investment grade or are no longer rated.

Only one issuer from our study subsequently defaulted. That issuer, PG&E Corp., was downgraded to 'BBB+' from 'A-' on Feb. 22, 2018, after it disclosed that it faced considerable risk exposure to the destructive California wildfires in 2017. In the rationale for the downgrade, S&P Global Ratings stated that the company's risk management capabilities were consistent with the prior ratings, and its inability to "understand and quantify and therefore adequately manage the wildfire risks" had weakened its credit profile. The company subsequently defaulted in 2019 after it filed for Chapter 11 bankruptcy as its risk exposure mounted.

Fewer of the issuers that were downgraded following voluntary management decisions (just 2%) were subsequently downgraded to speculative grade than those that were downgraded for other reasons (at 18%) (see chart 6). ). All of the issuers that were downgraded following M&A-related decisions were able to maintain investment-grade ratings, most due to subsequent leverage reduction. Of those downgraded to speculative grade, most faced disruption in their industries. This suggests that companies downgraded to 'BBB' after adopting more aggressive financial policies were largely able to maintain investment-grade credit profiles.

Chart 6

For nonfinancial corporates, we believe this underscores the strength of businesses in the 'BBB' category, since companies that migrated down the ratings scale following voluntary actions have generally maintained 'A' category business positions and have levers to pull in times of stress. In fact, 67% of nonfinancial corporates that were downgraded to the 'BBB' category after making voluntary decisions and that are still rated 'BBB' have business risk profile assessments of strong or better, compared to only 44% for the broader 'BBB' universe (see chart 7). This is particularly relevant when assessing the risk of becoming a fallen angel, since these companies currently hold nearly seven times more debt than nonfinancial corporates that were downgraded to 'BBB' for other reasons.

Chart 7

Nearly all of the nonfinancial corporates that were downgraded to 'BBB' and subsequently fell to speculative grade were not downgraded based on voluntary management decisions. Instead, most were downgraded on account of disruption in their industries. For example, companies such as Avon Products Inc., Pitney Bowes Inc., and Bed Bath & Beyond Inc. were slow to adapt to changing industry dynamics and e-commerce. S&P Global Ratings aims to capture these risks within its assessment of a company's competitive position relative to its industry, which would also influence how much leverage is tolerated at a given rating level.

For example, of the nonfinancial issuers downgraded to 'BBB' that subsequently fell to speculative grade, all currently have business risk assessments of fair or weak, at the lower end of S&P Global Ratings' business risk profile scale. By contrast, of the 14 nonfinancial issuers that remain in the 'BBB' category after being downgraded following voluntary management decisions, 86% have business risk profile assessments of satisfactory or strong, at the mid-to-upper end of S&P Global Ratings' business risk profile scale.

Appendix

In this study, we grouped the factors contributing to downgrades that we considered related to voluntary management decisions into the following categories:

M&A:  This category includes cases where the downgraded entity was either the target or buyer in an acquisition, as well as cases that involve mergers, leveraged buyouts, spinoffs, divestitures, and asset sales.

Aggressive financial policy:  These are cases where a company has chosen to increase its leverage or is taking on increased financial risk as part of a strategic decision. Often this includes companies that are pursuing more aggressive financial policies to support shareholder-friendly activities such as share buybacks and dividends, as well as capital expenditure.

Other factors that led to downgrades included:

Competitive position/industry risk:  These are cases where a company's business or financial risk profile has weakened as the company's performance has either declined or fallen short of expectations, leading to weakening credit measures. These downgrades can also include companies that face rising industrywide headwinds, such as cyclical or structural declines, as well as rising tariffs.

Regulatory:  These are instances where corporate issuer ratings were revised following a change in regulations or a regulatory action that affected the company's credit profile.

Criteria revision:  These are cases where a revision to S&P Global Ratings' criteria, or its application, results in rating changes.

Governance/risk management:  These are cases where S&P Global Ratings assessed that an issuer's corporate governance or its risk management framework showed a rising tolerance for risk or a deteriorating capability to manage risk. These downgrades could also reflect a growing awareness of deficiencies in corporate governance or an unexpected increase in potential risk exposure.

BICRA:  These are cases where a change in the Banking Industry Country Risk Assessment (BICRA) for a country leads to the downgrade of a company.

Table 1

Table 2

Related Research

• The 'BBB' U.S. Bond Market Exceeds $3 Trillion, May 29, 2019
• From Underdog To Top Dog: Charting The Growth Of 'BBB', April 26, 2019
• The U.S. Speculative-Grade Market Can Withstand 'BBB' Downgrades, April 24, 2019
• The Cost Of A Notch, March 26, 2019
• When The Cycle Turns: As U.S. 'BBB' Debt Growth Sparks Investor Concern, Near-Term Risks Remain Low, July 25, 2018