After hitting a record high in the second quarter of 2020, the number of U.S. corporate downgrades fell in the third quarter to its lowest level since fourth-quarter 2018. S&P Global Ratings lowered 107 U.S. corporate issuer credit ratings in the third quarter--74% fewer downgrades than in the second quarter--as upgrades nearly doubled to 43. Downgrades abruptly slowed and upgrades increased as U.S. GDP rebounded in the third quarter.

Chart 1

Negative Bias Declined As Economic Growth Rebounded

Downgrade potential began to dip in the third quarter for speculative-grade (rated 'BB+' or lower) companies after reaching a record high in the second quarter. Credit conditions turned less negative for companies as consumer spending held up better than expected after earlier fiscal stimulus. S&P Global economists predict U.S. GDP grew at an annualized rate of 29.5% in the third quarter, taking an abrupt turn from a 31.4% contraction in the second quarter.

The negative bias (which measures downgrade potential as the percentage of issuer credit ratings with negative outlooks or on CreditWatch with negative implications) for speculative-grade companies fell to 47% on Sept. 30, 2020, from 52% at the end of June.

Meanwhile, the negative bias for investment-grade (rated 'BBB-' or higher) companies held nearly unchanged at 26% (see charts 2 and 3). The overall negative bias (including both investment- and speculative-grade) fell by 3 percentage points to 41%.

Chart 2

Chart 3

The share of speculative-grade companies with ratings on CreditWatch with negative implications fell by more than half to near 3% in the third quarter, as downgrade risk continues to shift from the near term into the intermediate term (see chart 4). A rating on CreditWatch indicates a 1-in-2 chance of a rating change within the next 90 days, while a negative outlook indicates a 1-in-3 chance of downgrade within up to two years for investment-grade companies and generally up to one year for speculative-grade companies.

Chart 4

Lower-rated companies remain at highest risk of downgrades

While the negative bias declined for speculative-grade companies, their downgrade potential remains elevated. The risk is highest for the lowest-rated issuers, and we believe many sectors will not recover their pre-COVID-19 credit metrics until 2022 or, in some cases, 2023. With their weaker credit metrics, lower-rated entities are not as well positioned to weather a business, financial, or economic shock as higher-rated peers. The lowest rating level, 'CCC'/'C', has the highest negative bias, at 89%, followed by 'B+' with a negative bias of 45% and 'B-' with a negative bias of 44% (see chart 5).

Chart 5

With consumer spending proving resilient and GDP growth rebounding in the third quarter, the negative bias declined by 1 percentage point or more in 12 of 18 U.S. sectors (see chart 6).

Chart 6

The oil and gas sector now has the highest negative bias, at 69%, following a 12 percentage point decrease in the third quarter. S&P Global Ratings recently revised its West Texas Intermediate assumption for the remainder of 2020 to $35 per barrel from $25 (the 2021 assumption is unchanged at $45) and cut its assumption for 2022 to $45 from $50. While this change supports credit quality in the near term, these price assumptions are below the average break-even prices (near $50) for U.S. shale. As prices remain below break-even, weaker-rated companies, particularly those with large exposure to oil, remain vulnerable to negative rating actions. More than two-fifths of all rated companies in the sector are rated 'B-' or lower, and more distressed exchanges and bankruptcies are likely over the next year.

Although the negative bias for the automotive sector declined by 17 percentage points in the quarter, it remains elevated at 66% (see chart 7). The negative bias fell as U.S. light vehicle sales grew for four consecutive months through August. However, amid questions about the sustainability of recent demand, we expect sales to remain below 2019 levels through 2022. S&P Global Ratings currently forecasts U.S. light vehicle sales will decline 21% year over year to 13.3 million units in 2020. Speculative-grade auto suppliers have experienced the most credit deterioration in the sector.

The media and entertainment sector had the third-highest negative bias at the end of the third quarter, at 61%, down 3 percentage points since the end of the second quarter. S&P Global Ratings doesn't expect a recovery for out-of-home entertainment issuers from the leisure, live events, and movie exhibitor subsectors in the near term, given consumers may not return to venues until a vaccine is widely available. Even when credit metrics do recover, media and entertainment companies may remain at risk to negative rating actions, as existing secular pressures worsened because of the pandemic. With near 40% of all rated issuers in the sector rated 'B-' or lower, more negative rating actions are likely, especially if the economic recovery slows.

Chart 7

Only high tech shows a negative bias below its long-term average

One way we examine downgrade propensity is by comparing the current negative bias with the historical average. The number of sectors with above-average negative bias fell to 17 in the third quarter after all 18 sectors had above-average negative bias at the end of the second quarter. Currently, only the high technology sector displays a negative bias below its long-term average, as credit quality in this sector has held up relatively well amid the pandemic. In particular, rated companies in the services, hardware, and semiconductors subsectors have performed better than expected.

Chart 8

The sectors with current negative biases that are highest above their historical averages are oil and gas and autos (see chart 9).

We use a similar approach to gauge upgrade potential, comparing the current positive bias (the proportion of issuer credit ratings with positive outlooks or on CreditWatch with positive implications) of a sector with its long-term average. As we saw in the second quarter, no sectors currently show above-average upgrade potential (see chart 10).

Chart 9

Chart 10

Downgrades Fell By 74% In The Third Quarter As Upgrades Nearly Doubled

U.S. corporate downgrades totaled 107 in the third quarter, a decline of 74% from the second quarter. Upgrades nearly doubled in the quarter to 43, the highest number since third-quarter 2019 (which also had 43 upgrades). Nonfinancial corporate issuers accounted for 102 downgrades and 39 upgrades. Financial services issuers had just five downgrades during the quarter and nearly as many upgrades (with four) (see chart 11).

Chart 11

Speculative-grade downgrades declined by 75% in the quarter, falling to 95, their lowest level since fourth-quarter 2018. Investment-grade downgrades fell to 12 in the quarter, matching the number from third-quarter 2019 (see chart 12).

The number of speculative-grade upgrades rose in the quarter to 40, reaching its highest level since second-quarter 2019. The number of investment-grade upgrades was unchanged at three (see chart 13).

Chart 12

Chart 13

Table 1

Downgrades Were Concentrated At The Lowest Ratings

Downgrades were increasingly concentrated among companies at the lowest rating levels in the third quarter. About 53% of downgrades were of issuers rated 'B-' and lower, up from 39% in the second quarter. Most of these downgrades were of companies rated 'CCC+' and lower, which have the weakest credit metrics and have been less resilient to the rapid deterioration of business and economic conditions.

Meanwhile, 47% of upgrades were also from issuers rated 'B-' and lower. Many of these upgrades reflected better-than-expected financial performance or improved refinancing prospects or liquidity (see chart 14).

Chart 14

Media And Entertainment And Consumer Products Led Downgrades

The media and entertainment sector had the highest number of downgrades for a third consecutive quarter, with 21, down from 80 in the second quarter. All of the third-quarter downgrades from this sector were of speculative-grade companies. Most rating actions in the sector have been concentrated among the travel, leisure, local media, live events, and movie exhibitor subsectors.

The consumer products sector had the second-highest number of downgrades, with 18, all of speculative-grade companies. Upgrades in the sector rose to six (from two in the second quarter). While consumer staples have experienced an increase in demand, which has been a modest credit positive, discretionary subsectors face material declines in sales and profits, and credit metrics will likely take two to three years to recover to 2019 levels. Downgrades in the third quarter were concentrated among issuers within the apparel, food service, and cosmetics subsectors. More negative rating actions in each sector are likely amid tighter financing conditions for weaker-rated issuers, but there are signs that credit deterioration might have peaked.

Downgrades in the oil and gas sector fell to 12 in the third quarter from 48 in the previous quarter. All of these downgrades were of speculative-grade issuers.

The utility sector had the fourth-highest number of downgrades in the quarter, with 11. These downgrades were largely of speculative-grade midstream companies, for which lower commodity prices have affected the creditworthiness of their upstream counterparties.

Although the financial institutions sector had a relatively low number of downgrades, with three, it had the most debt affected by downgrades in the quarter. The downgrade of Wells Fargo & Co. to 'BBB+' from 'A-' accounted for nearly all downgraded debt in the financial institutions sector in the quarter. Wells' overall creditworthiness has declined given the company's ongoing regulatory challenges and preprovision earnings pressures amid the economic downturn.

Chart 15

Table 2

Fewer Fallen Angels In The Third Quarter

Fallen angels (issuers downgraded to speculative grade from investment grade) totaled three in the third quarter, down from six in the second quarter. These were aerospace company Howmet Aerospace Inc., fashion retailer Nordstrom Inc., and natural gas pipeline operator Southeast Supply Header LLC.

There was one rising star (an issuer upgraded to investment grade from speculative grade) in the quarter: Mediacom Communications Corp.

Table 3

Defaults Remain Elevated

The default tally fell to 37 in the third quarter from 62 in the second. Despite the decline, defaults remained considerably higher than in third-quarter 2019 (when 13 companies defaulted). Through Sept. 30, U.S. corporate defaults in 2020 totaled 120, more than double the number over the same period last year.

Even as defaults remain elevated, the number of issuers at greatest risk of default declined in the third quarter. The number of weakest links (issuers rated 'B-' or lower with negative outlooks or ratings on CreditWatch negative) fell to 391 during the quarter from 431 at the end of the second quarter. Still, the number of weakest links is twice as high as in third-quarter 2019. The elevated number supports our view that the U.S. trailing-12-month speculative-grade corporate default rate will continue to climb, reaching 12.5% in June 2021.

Table 4

Table 5

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

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• COVID-19 Heat Map: Updated Sector Views Show Diverging Recoveries, Sept. 29, 2020
• Credit Conditions North America: Potholes On The Road To Recovery, Sept. 29, 2020
• 'BBB' Pulse: Potential Fallen Angels Remain Stable In August, With Five Outlook Revisions To Stable And Just One Downgrade, Sept. 28, 2020
• Global Auto Sales Forecasts: Hopes Pinned On China, Sept. 17, 2020
• The Gap Between Market Expectations And Credit-Based Indications Of U.S. Defaults Is Growing, Aug. 27, 2020
• Credit FAQ: How S&P Global Ratings Factored Counterparty Risk Into Recent Midstream Energy Rating Actions, Aug. 26, 2020
• COVID-19 Battered Global Consumer Discretionary Sectors But Lifted Staples; Recovery Varies By Subsector, Aug. 4, 2020
• U.S. Corporate Downgrades Rise To A New High In Second-Quarter 2020, July 15, 2020