The number of potential bond downgrades decreased to 1,270 in October from 1,308 in September (see chart 1) after hitting its all-time high of 1,365 in July. The tally rose consistently since April 2019 and picked up significantly in February this year as the coronavirus pandemic muted business activity globally and roiled markets, characterized by rapidly widening credit spreads, panic selling, and investors' extreme risk aversion. Potential bond downgrades are issuers rated 'AAA' to 'B-' by S&P Global Ratings with either negative rating outlooks or ratings on CreditWatch with negative implications.

In October, we added 38 issuers to our list of potential downgrades and removed 82, 54 due to outlook or CreditWatch revisions, 15 due to outlook or CreditWatch changes accompanied by downgrades, two due to outlook or CreditWatch changes accompanied by upgrades, and three due to downgrades. Although it remains at historically high levels, the tally of potential bond downgrades has declined, pointing to some easing in downgrade potential over the coming months. Also, the ratio of negative outlooks to CreditWatch negative increased again--to 12.6 to 1 in October from 11.5 to 1 in September and 4 to 1 in May. This indicates that the pace of downgrades in the near time will continue to slow.

Chart 1

An examination of the proportion of potential bond downgrades placed on CreditWatch negative in crisis periods (defined as months with more than 80 downgrades) shows that an increase is followed by a rise in downgrades. On average, a rating on CreditWatch negative has a 50% likelihood of being lowered in the next 90 days, compared with a 1-in-3 chance and a two-year time span (one year for speculative grade) for a rating with a negative outlook. The longer time horizon gives more room for an issuer's business and financial risk profiles to improve. An issuer is placed on CreditWatch negative when there is an event or a deviation from an expected trend or material change in the performance of an issuer but the magnitude of the rating impact has not been determined. This may not necessarily lead to a downgrade, but the tight timeline of 90 days indicates a high likelihood that rating action in the direction mentioned in the CreditWatch will follow ("S&P Global Ratings Definitions," Dec. 7, 2020).

Furthermore, the gap between potential downgrades and potential upgrades (issuers rated 'AA+' to 'B-' by S&P Global Ratings with either positive outlooks or ratings on CreditWatch with positive implications) narrowed again, indicating that credit quality continues to recover. Potential bond upgrades total 147 as of October, the highest count since March when markets rapidly deteriorated. Relative to September, we added 42 issuers to the list of potential upgrades, 36 of which due to a change in outlook or CreditWatch. At the same time, we removed 12, six of which were upgraded.

That said, potential downgrades still far exceed potential upgrades by 8.6 to 1, signaling more credit deterioration to come, albeit at a slower pace than seen in the spring. Market volatility will continue to strain the operations of lower-rated issuers as they face tighter business conditions and insolvency risks.

Financing Institutions Overtake Media And Entertainment As The Sector With The Highest Downgrade Potential, Though Materially Lower As A Proportion Of Rated Issuers

Financial institutions continue to lead the tally of potential bond downgrades in October, after having overtaken media and entertainment in September (see chart 2). The sector's potential downgrades total 167, with nine removals from the list and six additions. While the number of potential downgrades in media and entertainment and consumer products remains elevated, particularly companies that sell through their own brick-and-mortar retail channels, the sectors saw a net decline in issuers poised for downgrades. Considering the number of rated issuers in financial institutions and utilities, however, the elevated count of potential downgrades in both sectors is smaller, as a proportion of the rated universe, than it is for media and entertainment.

Chart 2

Chart 3

Within financial institutions, negative bias (the share of issuers with negative outlooks or ratings on CreditWatch with negative implications) surged the most in consumer finance, where 21 issuers, or 68% of the rated universe, carry downgrade potential (see chart 4). This illustrates the sector's exposure to uncertainties in the labor market and earnings prospects amid the economic downturn. One-third of rated entities in the sector (of which 85 are on our list of potential bond downgrades) face downgrade potential, mainly because of rating actions taken closer to the onset of the pandemic after S&P Global lowered its economic forecasts (see "How COVID-19 Is Affecting Bank Ratings: October 2020 Update," Oct. 22, 2020).

However, S&P Global Ratings thinks that the sharp rebound in global growth expected in 2021, together with strong bank balance sheets, support from authorities to retail and corporate markets, and regulators' flexibility, should limit bank downgrades in 2021 (see "Banks Will Face The Next Test Once Support Wanes," Nov. 17, 2020).

Chart 4

The tally of potential bond downgrades in financial institutions rose to 167 as of October, from 74 as of December last year (see chart 5). Only 20% of the current potential downgrades were on our list at year-end 2019. Banks had 71 additions over the year through October, compared with 62 for nonbank financial institutions. This underlines banks' particular exposure to sectors vulnerable to COVID-19. The negative bias in both sectors, accounting for the size of the rated universe, is relatively similar.

Chart 5

The regional breakdown of financial institutions shows that we added 32 European banks to our list, and only 10 from the U.S. (see chart 6). Nonbank financial institutions account for 40 U.S.-based and 14 European-based additions. Beyond the larger share of European banks and U.S. nonbank financial institutions, in our global rated universe, these numbers also reflect regional differences in downgrade pressures. In Europe, additions to the potential bond downgrades list this year make up 41% of the rated universe for banks, and 20% for nonbank financial institutions. The opposite applies in the U.S., where new potential bond downgrades this year make up 23% of the rated universe for banks, and 40% for nonbank financial institutions.

The importance of bank loans for European corporates plays a role--in the eurozone, about four-fifths of corporate financing comes from banks, compared with one-fifth in the U.S. As a consequence of strong loan demand by firms on the back of state-backed guarantee schemes, and the central banks providing ample liquidity with monetary policy stimulus, European banks have increased their lending to the private sector. In addition, to place their excess liquidity--further driven by surging, largely involuntary, household savings--European banks purchased almost €210 billion worth of sovereign bonds between February and September. Therefore, the sovereign-bank nexus in the region deepened (see "The European Sovereign-Bank Nexus Deepens By €200 Billion," Sept. 21).

The high negative bias (see chart 7) illustrates the particular exposure of European banks, and incorporates our view of preexisting profitability issues.

Chart 6

Chart 7

We analyzed the rating rationales for all 167 financial institutions in our current crop of potential bond downgrades. More than half of all outlook or CreditWatch revisions are due to economic or operational impacts (see chart 8). This is most pronounced in consumer finance (71%), followed by banks (58%) and diversified services (54%), compared with only 27% in capital markets. Twelve of the 85 banks (14%) and one issuer out of 13 in diversified financial services saw changes to their ratings following sovereign rating changes.

Chart 8

Over The Past Three Months, More Issuers On The Potential Downgrades List Experienced Outlook Or CreditWatch Revisions Than Downgrades

Out of the 1,365 issuers on our list in July, when the count of potential bond downgrades was at its all-time high, 247 have seen a change to their ratings (see chart 9). This includes 97 downgrades, 40 of which were accompanied by outlook or CreditWatch changes, 127 revisions to outlook or CreditWatch, 13 rating withdrawals, and three defaults. Only 47 of the issuers that experienced rating changes over the past three months were still part of our potential downgrades count in October.

With 17 downgrades, the media and entertainment sector (including leisure and lodging)--particularly vulnerable to social distancing measures--had the strongest credit deterioration since July. Over the same period, the sector saw 16 outlook or CreditWatch revisions, pointing to some stabilization and less credit deterioration to come. By October, potential downgrades in the media and entertainment decreased to 155 from 175 in July.

Chart 9

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