Chart 1

Credit quality among corporations rated by S&P Global Ratings in the U.S. (including the tax havens Bermuda and the Cayman Islands) continued to show signs of softening in the third quarter of 2019. Defaults were up 63% year over year. Downgrades rose for the fourth consecutive quarter. And overall downgrade potential (investment grade and speculative grade) rose incrementally, to 19%. We measure downgrade potential using negative bias (the percentage of ratings with negative outlooks or on CreditWatch with negative implications).

While the current U.S. economic expansion is now the longest in history, the economy shows signs of slowing. S&P Global economists forecast U.S. GDP growth will decline to 2.3% for full-year 2019, from 2.9% in 2018, with growth slowing further to 1.7% in 2020. While this slowing economic growth will likely challenge the growth of corporate earnings, it presents opportunities for lowered funding costs. The Federal Reserve has lowered rates twice already in 2019, and we expect one additional rate cut this year, depending on the data.

Amid ultralow borrowing costs for companies, a growing share of corporate ratings are concentrated at the lowest rating levels. Nearly 28% of U.S. speculative-grade issuers (rated 'BB+' or lower) were rated 'B-' or lower at the end of the second quarter, and these lower-rated entities typically show less resilience in downturns.

The current negative bias of 19% is the highest since December 2016. Notably, at that time, downgrade risk was largely concentrated in the oil and gas sector, while current downgrade risk is spread across sectors: Seven out of 18 sectors now show negative biases that are higher than their long-term averages.

The negative bias for speculative-grade companies rose by 1 percentage point to 21% in the third quarter, and investment-grade (rated 'BBB-' or higher) negative bias remained steady at 12%. Meanwhile, the positive bias (the percentage of ratings with positive outlooks or on CreditWatch with positive implications) declined for speculative-grade companies to 6% from 7%, and the positive bias for investment-grade companies remained unchanged at 4% (see charts 2 and 3).

Chart 2

Chart 3

The Auto Sector Still Leads In Downgrade Potential, But Oil And Gas And Retail Are Catching Up

The auto sector had the steepest increase in negative bias over the past year, rising by 22 percentage points to 31% (see chart 4). Downgrade potential within the sector has risen in recent quarters, as pressures in the aftermarket and operational missteps by some Tier 1 auto suppliers have driven most of our negative rating actions.

While S&P Global Ratings expects U.S. light-vehicle sales to decline by nearly 3% year over year in 2019 before stabilizing in 2020 and 2021, overall, we don't expect this modest dip in auto sales (in our base case) to lead to downgrades for automaker and supplier ratings in 2019-2020. Our forecast sales levels remain healthy enough for most automakers and suppliers to operate with healthy EBITDA margins, and we believe significant new product launches will support automakers' current product mix in favor of trucks.

Chart 4

The oil and gas, retail, and telecommunications sectors follow, each with a negative bias of 26%. Negative bias in the oil and gas sector rose by 5 percentage points over the past year, including an increase of 2 percentage points in the third quarter. Credit stress in oil and gas has been on the rise as companies cope with volatile energy prices, liquidity issues, and high leverage. Moreover, capital market access has not been favorable for the sector, especially those deep speculative-grade issuers, and some issuers are conducting distressed exchanges for debt that is trading at very low prices.

Although the negative bias for the retail sector remains elevated, it has fallen by 4 percentage points over the past year. This sector continues to face challenges from rising tariffs and changing consumer preferences.

Meanwhile, the negative bias in the telecommunications sector was little changed from the second quarter. The transportation sector recorded the greatest quarterly dip in negative bias, dropping by 6 percentage points in the third quarter to 11%. High technology was the nonfinancial sector with the lowest negative bias, at 9%.

Chart 5

One way we examine downgrade propensity is by comparing the current negative bias with the historical average (see chart 6). Currently, the seven sectors with above-average downgrade potential are oil and gas; autos; health care; aerospace and defense; utilities; telecommunications; and chemicals, packaging, and environmental services.

In late 2016, the last time that the U.S. corporate negative bias was at a comparable level, just five sectors showed above-average downgrade potential. During that prior period, much of the downgrade risk was concentrated in the oil and gas sector. In the current cycle, downgrade risk is more widespread across sectors.

Chart 6

The sectors that show the most upgrade potential (the highest positive biases) as of the end of the third quarter are metals, mining, and steel (15%) and homebuilders and real estate (11%). These, along with financial institutions, are the only sectors exhibiting above-average upgrade potential as of Sept. 30, 2019.

The positive bias for the metals, mining, and steel sector is more than 6 percentage points above its long-term average, while the positive biases for the homebuilders and real estate sector and financial institutions are less than 0.5 percentage point above their long-term averages (see chart 7).

Chart 7

The U.S. Corporate Downgrade Ratio Rose To 73%

The downgrade ratio (the share of rating actions that were downgrades) for U.S. corporates rose 6 percentage points to 73% in the third quarter. Meanwhile, the number of upgrades declined notably from the second quarter, slumping by 15 to 43, while downgrades rose by two to 119.

Further, the amount of debt affected by downgrades was three and a half times the amount of upgraded debt. The debt affected by downgrades rose by 65% to $333 billion, while the amount of debt affected by upgrades fell by more than half to $96 billion (see table 1).

Table 1

U.S. corporate downgrades reached their highest level (at 119) in the third quarter since the third quarter of 2016. The increase was exclusively from nonfinancial companies, while financial services downgrades declined in the quarter. Upgrades declined among both financial and nonfinancial companies during the quarter (see chart 8).

Chart 8

Nearly 35% of total downgrades in the quarter were from issuers with the lowest ratings ('B-' and below). The number of investment-grade downgrades rose by seven to 12 (see charts 9 and 10). The highest-rated company among the investment-grade downgrades was Oracle Corp., which was downgraded to 'A+' from 'AA-' on July 2, 2019, on continued elevated share buybacks.

Chart 9

Chart 10

The Oil And Gas And Consumer Products Sectors Led Downgrades

The oil and gas sector had the highest number of U.S. corporate downgrades in the third quarter, with 23, an increase of nine from the second quarter. Two of these downgraded companies, Occidental Petroleum Corp. and Murphy Oil Corp., were investment grade. Murphy Oil Corp. was the sole fallen angel (an issuer downgraded to speculative grade from investment grade) from the sector in the quarter. Oil and gas had six defaults during the quarter.

The consumer products sector had the second-highest number of downgrades in the third quarter, with 18, down by one from the second quarter. The downgrades were almost exclusively from the spec-grade segment, with one fallen angel, Tupperware Brands Corp. Utilities led with the most upgrades in the quarter, at 13, up from just two in the second quarter (see chart 11 and table 2).

Chart 11

Table 2

The U.S. Corporate Default Tally Reached 13

The U.S. corporate default tally fell to 13 in the third quarter from 23 in the second quarter. However, year over year, the total number of U.S. corporate defaults has risen by 63% compared with the first three quarters of 2018. Third-quarter 2019 defaults were concentrated in the oil and gas and retail sectors, which together accounted for nearly half of the defaults in the quarter. We expect the U.S. trailing-12-month speculative-grade corporate default rate to rise to 3.4% by June 2020 from 2.4% at the end of the second quarter.

The pool of potential defaulters grew further in the third quarter as the number of weakest links increased to 179 from 167. Weakest links are issuers rated 'B-' or lower with negative outlooks or ratings on CreditWatch negative. Companies with low ratings such as these typically show the greatest default risk.

There were three new fallen angels and two rising stars (issuers upgraded to investment grade from speculative grade) in the third quarter. Two fallen angels (Tupperware Brands Corp. and Murphy Oil Corp.) were downgraded to 'BB+' from 'BBB-', while the other (Stericycle Inc.) was downgraded to 'BB' from 'BBB-'. Meanwhile, rising stars Host Hotels & Resorts Inc. and Global Payments Inc. were each upgraded to 'BBB-' from 'BB+'.

The number of potential downgrades (issuers with negative outlooks or ratings on CreditWatch with negative implications) increased slightly, to 331, and the number of potential upgrades (issuers with positive outlooks or ratings on CreditWatch with positive implications) decreased to 138 from 151 (see table 3).

Table 3

Table 4

Related Research

• U.S. Auto Sector Faces Bumpy Roads Ahead With Rising Recession Odds And Falling Demand, Oct. 16, 2019
• Media And Entertainment Defaults Reach A Six-Year High, Oct. 10, 2019
• The Distress Ratio Ebbs After Oil And Gas Defaults, Oct. 10, 2019
• A Double-Digit U.S. Default Rate Could Be On The Horizon, Oct. 2, 2019
• Will Trade Be The Fumble That Ends The U.S.'s Record Run?, Sept. 27, 2019
• The U.S. Speculative-Grade Corporate Default Rate Is Set To Rise To 3.4% By June 2020, Aug. 22, 2019