Second waves of coronavirus are forcing many countries to adopt strict social distancing measures once again. Our credit indicators suggest that fallen angel risk is now lower than during the June peak, reflecting the headroom that entities rated in the 'BBB' category have gained on the back of a liquidity surge over the summer, as well as a stronger-than-expected economic rebound in the third quarter. Central bank interventions (both direct and indirect) have helped credit markets produce the highest annual issuance totals ever, allowing many companies to accumulate the needed funds to wait out the pandemic for an extended period. Nonetheless, our current negative bias for 'BBB' nonfinancials remains high in the U.S. and EMEA, as is the risk of sluggish economic activity with lockdowns in place in many countries. (Negative bias is the proportion of issuers with negative outlooks or ratings on CreditWatch negative.)

Here we update our fallen angel projection in light of recent history and the unclear path ahead. We estimate, based on our updated hypothetical scenario, that fallen angel debt will total roughly $295 billion for the period October 2020 through year-end 2021 (see chart 1).

Chart 1

'BBB' Fallen Angel Debt Projected To Reach $295 Billion

In our hypothetical scenario, we estimate the amount of long-term nonfinancial corporate 'BBB' debt vulnerable to downgrade to speculative grade. We do this by assigning fallen angel probabilities for each rating and outlook or CreditWatch combination among companies rated in the 'BBB' category by S&P Global Ratings in the U.S. and EMEA on Oct. 31, 2020. These hypothetical relative probabilities and the approach used to generate the estimates are summarized in table 2 in the appendix. The estimated results of this hypothetical scenario were:

• For the U.S., roughly $190 billion, or about 6.5% of the outstanding total long-term 'BBB' debt on Oct. 31, is vulnerable to downgrade to speculative grade through year-end 2021.
• In EMEA, the equivalent figures are $105 billion and 4.8% of long-term 'BBB' debt.
• Combined, approximately $295 billion in 'BBB' debt could fall to speculative grade through 2021.

These estimates are much lower than the ones from April, both in absolute and relative terms. Since then, the outstanding amount of 'BBB' nonfinancial debt in the U.S. and EMEA has increased--largely a result of downgrades from 'A'. As of Oct. 31, there is roughly $3 trillion in outstanding 'BBB' nonfinancial debt, from $2.7 trillion previously--an increase of 10.6%. In EMEA, the total has seen an even larger increase (27%), to $2.2 trillion from $1.7 trillion.

Outside of the U.S. and EMEA, another $826 billion in 'BBB' nonfinancial corporate debt is outstanding across roughly 337 issuers. Most are carrying rather modest debt loads, but some have large debt totals or are susceptible to downgrade if their related sovereign is downgraded. A notable example is PEMEX, which accounts for approximately $93 billion in debt. S&P Global Ratings lowered its long-term foreign-currency rating on PEMEX to 'BBB' from 'BBB+' following the downgrade of Mexico (foreign currency lowered to 'BBB' from 'BBB+'). Most of the largest issuers outside of the U.S. and EMEA (those with over $10 billion in outstanding debt) are rated 'BBB+', with over half coming from Canada. Of the 16 issuers in this category, only Nissan Motor Co. Ltd. of Japan is rated 'BBB-' with a negative outlook (accounting for $16.5 billion in debt).

Ample Liquidity, Historically Favorable Conditions, And Record Issuance

As reported previously, market liquidity aggressively resumed for 'BBB's in the U.S. and EMEA following massive corporate bond facilities created by the European Central Bank (ECB) and the Fed in mid-March (see "'BBB' Pulse: Market Liquidity For 'BBB' Rated Debt Remains Undeterred Despite High In Fallen Angels," Aug. 27, 2020). These moves have benefited most areas of the investment-grade and speculative-grade markets in both regions, but the relative improvement has been greater for bonds rated 'BBB' and higher, with spreads falling steadily during the second and third quarters (see chart 2). As of Nov. 12, U.S. secondary 'BBB' corporate spreads reached 166 basis points (bps), the lowest level since Feb. 27.

Chart 2

While credit risk is still more elevated for 'BBB's than spread levels at the start of the year, their relative funding costs have been falling since March, reaching record lows over the summer (see chart 3). This is also true for all investment-grade rating categories and, of course, U.S. Treasuries. Secondary industrial yields in the U.S. reached historical lows around early August and have risen only slightly since. For example, 'BBB' secondary yields reached an all-time low of 2.44% on Aug. 4, but they only increased to 2.5% by Nov. 13.

Meanwhile, 10-year U.S. Treasury yields remain below 1%, though they have been flirting with that level recently as positive news on the vaccine front continues to roll out, increasing optimism for a resumption of normal levels of economic activity by mid-2021. At its 2020 low, the 10-year Treasury yield reached 0.49% on March 9 and dipped below 0.6% in early August after rising slightly since April. These ultralow benchmarks are a major contributor to still elevated spread levels for 'BBB's.

Chart 3

Primary yields have also fallen this year (see chart 4). In fact, nonfinancial 'BBB's faced average yields-to-maturity in the third quarter of 2020 that were slightly lower than those on 'AA' rated issues in the fourth quarter of 2019. Primary yields on 'BBB' deals were even lower in Europe during the third-quarter, though primary yields there have been depressed for several years amid--in many countries--negative-yielding sovereign debt.

In addition to lower yields, investment-grade deals have seen their average maturity lengths increase in 2020, making for a potent combination of lower costs for longer on recent debt.

Chart 4

Companies across nearly every region have taken advantage of these favorable financing conditions by issuing record amounts of debt in the second quarter (see chart 5). And though issuance saw a pullback during the third-quarter, the three months ended September still produced the second-highest quarterly total globally.

Chart 5

Through the COVID-19 shock, investment-grade and speculative-grade issuers have faced considerably different levels of potential stress. This is typical in any downturn, though may be more accentuated this year due to targeted support for investment-grade issuers by the Fed and ECB liquidity programs, as well as the rapidly impeded revenue generation capabilities of many companies in the higher-leverage, speculative-grade segment. The cost of being downgraded to speculative grade (as measured by the difference in observed spread between 'BB+' and 'BBB-' bonds) shot up to 141 bps in the spring--even higher than the jumps during the financial crisis. However, this gap between adjacent ratings' spreads has remained elevated (though is falling) despite that overall spread levels having fallen considerably since late March (see chart 6).

This large gap is especially noteworthy considering that recent central bank policies have either directly included recent fallen angels--as is the case with the primary and secondary corporate facilities by the Fed--or indirectly via their inclusion as eligible collateral for loans extended by the ECB.

Chart 6

But Risks Remain

Favorable market conditions prompted by central bank supports have been a marked benefit to corporations since March--particularly so for investment-grade issuers. Nonetheless, credit stress for 'BBB's was not totally unavoidable. In fact, in both the U.S. and EMEA, nonfinancial 'BBB's continue to see increased downgrade rates, which have already hit high points not seen since the financial crisis (see chart 7).

Chart 7

Despite the increased fallen angel rates thus far, they are still below the downgrade rates during 2008-2009, especially in EMEA. Market optimism following recent vaccine development and efficacy announcements should provide a tailwind to positive sentiment. However, the U.S. and EMEA are currently contending with rising case numbers, increasingly burdened health care systems, and another wave of lockdowns--all of which could weigh on 'BBB's, particularly in sectors most exposed to social distancing.

The pace of global fallen angels in 2020 may still be below peaks of prior years, but upgrade potential has been particularly limited for 'BB's (see chart 8). The number of rising stars is on track for an all-time low in 2020--in fact, well below even levels seen in the financial crisis and the dot-com recession. Thus far in 2020, rising stars total just six (see table 4) as credit stability, rather than broader improvement, is in a relatively nascent stage.

Chart 8

On a possible positive note, future lockdowns are more likely to be less restrictive than those in the spring, which should limit some of the economic damage over the winter months. This, combined with our forward-looking views, would seem to indicate a slower pace of future downgrades (see charts 9 and 10).

Negative bias in the U.S. remains elevated, particularly for 'BBB-' nonfinancials (31% in October), but this has been falling quickly since the recent peak in June (36%). Meanwhile, the negative bias for 'BBB' fell in October from an all-time high of 32% in September.

Chart 9

In EMEA, negative bias was also elevated in October, though is still lower than its peaks in June. One key difference between the U.S. and EMEA is that negative bias levels (and fallen angel rates) in EMEA were much higher during the financial crisis than in 2020.

Chart 10

Although overall negative bias levels are still relatively high, near-term fallen angel potential has lessened globally in recent months (see chart 11). The proportion of potential fallen angels with ratings on negative CreditWatch (versus those with negative outlooks) hit a three-year low of 4% in November. This is the fourth-lowest monthly reading since April 2008. Negative outlooks reflect both reduced probabilities and lengthened expected timing of downgrades (1 in 3 chance of downgrade within two years of outlook) versus CreditWatch negative placements (1 in 2 chance of downgrade within 90 days of placement).

Chart 11

Potential Fallen Angels Are Concentrated In The Highly Affected Sectors

The pandemic and social distancing measures have had an uneven impact on nonfinancial corporate borrowers--in particular, the travel, retail, and leisure sectors. Additionally, the oil price collapse that pushed spot oil prices briefly into negative territory, has taken its toll on oil and gas producers as well as refiners and midstream companies. It could take until 2022, 2023, or beyond for some of these sectors to recover pre-pandemic credit metrics (see "COVID-19 Heat Map: Updated Sector Views Show Diverging Recoveries," Sept 29, 2020).

About $248 billion, or nearly three-fourths, of potential fallen angel debt is from six sectors that have been highly impacted by the pandemic or oil and gas dislocation this year. (Potential fallen angels are issuers rated 'BBB-' with negative outlooks or ratings on CreditWatch with negative implications.) Additionally, the two largest potential fallen angels, Boeing Co. ($50.2 billion of debt) and Energy Transfer LP ($47.3 billion), are in the highly impacted transport/aerospace and oil and gas/midstream sectors, respectively.

However, the size of issuers on the weakest rung of investment grade drops off quickly after the two largest borrowers (see chart 12). To put this risk into context, potential fallen angel debt represents only 6.6% of 'BBB' category debt, and we don't envision large transitions to speculative grade, even from these weakest 'BBB's, baring a weaker-than-expected recovery, a double-dip recession, or delays in widespread vaccine availability beyond mid-2021.

Table 1

The impact descriptor (high, moderate, low) is our qualitative view of the degree of impact (due to COVID-19, global recession, or the collapse of oil and gas markets in 2020) on the sectors' operations and credit metrics. It does not directly translate to risk of rating actions, which depend on a number of factors, including initial headroom under a rating coupled with the expected length and severity of the crisis. The recovery column indicates our estimates of when credit metrics might reach a run-rate recovery back to 2019 levels.

Chart 12

The Broader 'BBB' Category Rated Population Is More Balanced Across Sectors

While potential fallen angels remain concentrated in the highly affected sectors, the broader 'BBB' category rated population looks much more balanced across sectors. Also, two of the three largest sectors, consumer products and telecom, have fared relatively well this year, for the most part. In terms of rating distribution, more than 80% of all 'BBB's are at least two notches above speculative grade ('BBB' and 'BBB+'). Here we expand on the three largest sector concentrations within the 'BBB' rated population.

Telecommunications ($828 billion, or 16.1% of 'BBB' category rated debt)

Telecommunications is one of the least affected sectors by COVID-19 in 2020. Trends toward working, learning, and streaming from home highlight the need for reliable broadband connections. This demand, along with stable wireless demand, has provided stability to offset the effects of a weaker economy. We expect some weakness in top-line trends and profitability in 2020, but credit quality should not deteriorate significantly given telecom companies recurring, subscription-based business models. Issuers exposed to small and medium-size businesses customers are most likely to experience weaker revenue and cash flow over the next year.

Chart 13

Largest issuer: AT&T (BBB/Stable/A-2, $256 billion of debt).  While COVID-19 and a global recession will contribute to weaker top-line trends and lower EBITDA in 2020, we believe a downgrade is unlikely over the next 12-24 months. AT&T's leverage is expected to remain in the mid-3x this year and next.

Consumer products ($586 billion, or 11.3% of 'BBB' category rated debt)

While consumer staples benefited from the crisis and will likely experience a decline in organic sales next year as they lap strong comparisons, discretionary subsectors might benefit from pent-up demand and an increase in social activity, given they were hit hard by the pandemic and related fallout. We think most discretionary subsectors can regain a meaningful portion of their previous business, absent a prolonged recession.

However, there's potential for longer-term structural changes in the food service sector if independent and small chains exit and new entrants do not emerge. Travel retail might also not regain its pre-COVID-19 demand given airlines' cutback in flights and businesses finding virtual meetings effective.

A mitigating factor to the concentration of consumer product debt rated in the 'BBB' category is that most of the debt (57.5%) is rated 'BBB+'--three notches above speculative-grade territory.

Chart 14

Largest issuer: Anheuser-Busch INBev S.A./N.V. (BBB+/Negative/A-2, $150 billion of debt).  Anheuser-Busch was downgraded to the 'BBB' category in May as a result of the negative effects of COVID-19 on out-of-home beer consumption. The negative outlook reflects the risk that operating performance and credit metrics do not improve as anticipated in our base case from 2021 onward in the event of lockdown measures or a global recession that affects beer consumption into next year.

Oil and gas ($417 billion, or 8.1% of 'BBB' category rated debt)

Demand and prices fell dramatically in 2020 because of excess crude oil supplies and the COVID-19 pandemic impact. While the global oil market will rebound as the world economy recovers and lockdowns ease, the disruptions to both global oil demand and supply will persist far after the pandemic has ended, with implications for the energy transition. For demand, individuals and businesses forced to reduce travel during lockdowns have identified potential long-lasting cost savings that will both blunt the recovery in consumption and reduce long-term demand. Many businesses have made working from home arrangements permanent to reduce real estate needs and costs, and have signaled that business travel will be reduced for the foreseeable future. Any recovery for the sector will rest on the level of recovery in hydrocarbon prices.

Globally, 22 oil and gas companies are rated at the lowest rung of investment grade, 'BBB-', with nearly $120 billion of debt combined. There have already been a number of large mergers in the energy sector, including the Chevron Corp.-Noble Energy Inc. and ConocoPhillips-Concho Resources deals. We expect continued consolidation among exploration and production companies given a lower-for-longer price environment, lack of capital for the high reinvestment rates needed to feed the shale production treadmill, and investor unwillingness to continue funding smaller companies given historical losses and the inevitable transition to renewable energy sources.

Chart 15

Largest issuer: Enel SpA (BBB+/Stable/A-2, $72 billion of debt).  Enel SpA's operating performance has been solid throughout the COVID-19 pandemic, and 2020 reported EBITDA should increase to €18.0 billion from €17.7 billion reported in 2019, thanks to renewables additions and solid network performance. Despite the massive investments in networks and renewables over 2020-2022 averaging more than €10 billion, we expect our consolidated adjusted funds from operations to debt will remain well above the 21% threshold for the current rating.

Our COVID-19 Assumptions

S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use 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.

Appendix: Hypothetical Scenario Analysis Approach And Additional Information

This hypothetical scenario analysis included parent firms in the U.S. and EMEA rated in the 'BBB' category and all qualifying debt in their organizational hierarchies, as well as the qualifying debt of subsidiaries rated in the 'BBB' category, if their parents have other ratings. Reported debt included both secured and unsecured bank loans, subordinated debt, medium-term notes, preferred stock, convertible debt, and drawdowns under medium-term note programs. It did not include commercial paper programs, shelf registrations, revolvers, or certificates of deposit.

The hypothetical risk weights for the stable outlooks in table 2 approximate the relative long-term fallen angel rates in the U.S. and EMEA regions combined over a 12-month rolling horizon.

The risk weights applied to the negative and positive outlooks and CreditWatch statuses represent estimates for fallen angel potential given the current economic backdrop--with far more fallen angel risk among companies rated 'BBB-' and on CreditWatch with negative implications, and essentially no fallen angel risk for companies rated 'BBB+' with positive outlooks. We then multiplied the debt distribution by each corresponding risk weight in this scenario and summed the total. We used this to calculate a downgraded debt amount scenario through the end of 2021.

Table 2

Table 3

Table 4

Table 5

Table 6

Table 7

Table 8

Table 9

Table 10

Table 11

Related Research

• Seven Potential Fallen Angel Banks Across Asia-Pacific Face COVID-19 Threat, Dec. 1, 2020
• 'BBB' Pulse: Market Liquidity For 'BBB' Rated Debt Remains Undeterred Despite High In Fallen Angels, Aug. 27, 2020
• 'BBB' Pulse: U.S. And EMEA Fallen Angels Are Set To Rise As The Economy Grinds To A Halt, April 8, 2020
• 'BBB' Pulse: Vitals Remain Stable For The Largest Issuers, Nov. 25, 2019