Business Conditions Are Improving Faster Than Expected In Many Sectors

Robust economic growth in economies, including the U.S. and China, is contributing to a faster-than-expected improvement in business conditions in many sectors. While the pace is modestly accelerating for companies globally, 'BBB' nonfinancials in the U.S. and EMEA are showing a more rapid improvement.

We now estimate that 71% of 'BBB' debt is from sectors we expect to recover to 2019 credit quality in the near term (by early- to mid-2022), up from 47% in our prior report, (see “‘BBB' Pulse: Fallen Angel Downgrade Risk Is Set To Decline Sharply In 2021," April 14, 2021). For the detailed heat map by region and sector, see "COVID-19 Heat Map: Pent-Up Demand And Supply Shortages Further Improve Recovery Prospects For Credit Quality," June 8, 2021).

Sectors that we now expect to recover to 2019 credit metrics earlier than expected in the last report (up from the mid-term in our prior report), include:

• Metals, mining, and steel. We expect this sector to return to 2019 credit metrics this year as limited supply led to price increases given the quick resurgence in demand for metals and building materials.
• Chemicals. We now expect this subsector in North America and Europe to return to 2019 credit metrics in the second part of 2021, sooner than our previous expectation in 2022, as growing end-user demand in many regions is supporting the industry.
• Luxury goods. We now expect the luxury and discretionary subsectors of consumer products to return to 2019 credit metrics in 2022, as pent-up demand from the U.S. and China is contributing to a faster rebound in sales.

Even the sectors with a longer expected path to recovery are benefiting from the improving business conditions.

For oil and gas, rising prices support our view of a mid-term recovery in 2022 or early 2023.   Demand is boosted by the reopening of economies, and global oil supply remains supportive of these price gains. For now, we don't anticipate any significant ramp up in production in 2021, although it's unclear how long OPEC-aligned countries and U.S. shale producers will continue their disciplined production philosophy.

Media and entertainment face a longer-term recovery (2023 or later).   While the travel and leisure subsector will take years to recover to pre-pandemic credit metrics, the industry is showing early signs of recovery and has potentially reached an inflection point with the vaccinations, fiscal stimulus, and consumer savings, unlocking pent-up demand for leisure travel. The main risk to this scenario is a potential new wave of infections because of new COVID-19 variants.

Retail and restaurants broadly face a longer-term path to recovery.   While a return to 2019 credit quality for retail and restaurants is not expected before 2023 in EMEA, and 2022 in North America for the nonessential retailer subsector, essential retailers did not experience deteriorating credit quality, and U.S. restaurants are on track to recover later this year as the casual dining segment is improving. As a result, we've revised the rating outlooks of McDonald's Corp. and Starbucks Corp to stable (from negative), and Darden Restaurants Inc. to positive (from stable).

Fallen Angel Debt Is Projected To Decline To $112 Billion

Given these improving conditions, our estimate for fallen angel debt over the next 12 months has continued to decline. For our hypothetical scenario in this report, we estimated the amount of long-term nonfinancial corporate 'BBB' category rated debt vulnerable to downgrade to speculative grade over the next 12 months in the U.S. and EMEA (see table 5 in the appendix for a description of the approach used).

• We estimate about $112 billion in 'BBB' category debt from nonfinancial companies in the U.S. and EMEA could be downgraded to speculative grade over the next 12 months--representing about 2% of total 'BBB' nonfinancial debt (see chart 1).
• From the U.S., this includes roughly $77 billion, or about 2.4% of the outstanding total long-term 'BBB' debt on May 31.
• From EMEA, this includes around $35.4 billion, or 1.5% of outstanding nonfinancial 'BBB' debt.

While our estimate of fallen angel debt is markedly higher than the $12.7 billion in fallen angel debt in 2021 through May (see chart 1), there remains $216.4 billion in debt associated with potential fallen angels in the U.S. and EMEA, and these issuers continue to have elevated risk of downgrade to speculative grade.

Chart 1

The Number Of Potential Fallen Angels Continues To Decline

Over the past eight months, both the number and the debt amount of potential fallen angels has declined as the economic recovery gains traction across sectors. Since Feb. 28, the number of potential fallen angels in the U.S. and EMEA declined by 21% (to 41), and the associated debt fell by 25% over the same period (to $216.4 billion)--down by more than 40% since summer 2020 (see chart 2).

Chart 2

Much of the decline in potential fallen angels since February has followed as issuer rating outlooks were revised to stable (see chart 3). The largest issuer removed from the list of potential fallen angels since then is Energy Transfer L.P. We revised its outlook to stable as the company accelerated its leverage reduction using cash from operations (see "Energy Transfer L.P. Outlook Revised To Stable From Negative On Accelerated Leverage Reduction; 'BBB-' Rating Affirmed," May 7, 2021).

Chart 3

In addition to the outlook revisions and debt reductions of potential fallen angels since February, there is also an uptick in rising stars (issuers upgraded to investment grade from speculative grade). Nonfinancial rising stars outnumber fallen angels, 14 to 5 in the U.S. and EMEA in 2021 (through May), with $61 billion in debt associated with rising stars. This is well in excess of the just $12.7 billion in debt of fallen angels over the same period.

Additionally, there are nine potential rising stars (issuers rated 'BB+' with either positive outlooks or ratings on CreditWatch with positive implications) in the U.S. and EMEA, and two of these issuers (Dell Technologies Inc. and Netflix Inc.) account for most of the debt of potential rising stars globally.

Chart 4

With Credit Stabilizing, The Pace Of Downgrades Continues To Slow

The deterioration in credit metrics has slowed considerably in recent months with the economic rebound. The trailing 12-month 'BBB' downgrade rate fell to 4.2% in the U.S., (from 6.3% in February) and to 3.0% in EMEA (from 7.5%) (see chart 5). Additionally, the negative bias (the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications) for 'BBB' companies continues to fall, suggesting a further decline in downgrades.

The negative bias for 'BBB' issuers declined by eight percentage points since February (to 16%) in the U.S., and by four percentage points (to 18%) in EMEA, as performance has improved broadly across sectors (see chart 6).

Chart 5

Chart 6

In many cases, the recovery is leading to positive forecast revisions and increased upgrade potential. The positive bias (the proportion of issuers with positive outlooks or ratings on CreditWatch with positive implications) for 'BBB' issuers increased by one percentage point in both the U.S. and EMEA.

Despite Inflation Concerns, Financing Conditions Remain Highly Supportive For 'BBB' Issuers

Questions around the extent and pace of inflation and its effect on interest rates have been at the forefront of investors' concerns throughout this year.

This concern was apparent in the first quarter, as the U.S. 10-year Treasury yield rose by around 80 basis points (bps)--reaching 1.75% by March 31. The 'BBB' yield rose by nearly 70 bps over the same period after hitting an all-time low of 2.32% at the start of 2021.

Chart 7

Since the first quarter, funding costs have been relatively more stable, albeit higher than at the start of the year. The 10-year Treasury yield and the 'BBB' yield modestly fell by 15 bps and 20 bps, respectively, in the second quarter through May. However, surprise year-over-year inflation figures and Chairman of the Federal Reserve Jerome Powell's comment that the Federal Reserve is "talking about talking about" bond tapering, suggest the risks regarding market reflation may not yet be behind us.

Funding Costs Have Risen In 2021, But From Record Lows

Even with funding costs rising year-to-date, they are rising from record lows. Additionally, the increase year-to-date in treasury yields has coincided with a further spread compression for 'BBB' bonds, mitigating some of the increase in funding costs. The 'BBB' composite spread narrowed to its tightest level since 2007, reaching 122 bps on May 27.

Chart 8

Meanwhile, the cost of notch between 'BBB-' and 'BB+' remained relatively stable in the second quarter. Even if fallen angels would have slightly less capacity to raise funding than an investment-grade issuer, the incremental financing costs of being downgraded to speculative grade have stabilized well below their COVID-19-related highs, and remain just five basis points wider than the long-term average (see chart 9).

Chart 9

While 'BBB' issuers are not exempt from rising inflation and funding costs, they are relatively well-positioned in the current environment of economic expansion. With funding costs at the current lows, 'BBB's should be able to absorb a normalization in funding costs. Most 'BBB' debt is in fixed-rate bonds, and companies have several years before this debt reaches maturity as the median maturity of 'BBB' corporate bonds in the U.S. and EMEA is 6.1 years.

Chart 10

'BBB' financing conditions remain supportive, despite lower issuance volume. 'BBB' bond issuance in 2021 is down 41% through May in the U.S. (and down 12% in EMEA), but this is in comparison with the record-shattering volumes of 2020. 2021's 'BBB' bond issuance volumes of $175.7 billion in the U.S. (and $67.3 billion in EMEA) are 44% higher than issuance over the same period in 2019 in the U.S. (and 16.5% higher in EMEA), (see charts 10 and 11).

Chart 11

Credit Trends At The Cusp Of Investment Grade Continue To Improve, As Rising Stars Increase

Consistent with our estimates for a decline in fallen angel debt over the next 12 months, improving credit trends around the cusp of investment grade globally continue, especially in more developed regions. While rising stars continue to gain momentum, and fallen angels continue to decline, the steepness of the drop in fallen angels has not been matched by an equal increase in rising stars.

Globally (including financial services and sovereign issuers, in addition to nonfinancials), the number of rising stars to fallen angels rises to 16 to 12, and these downgrades include four that are government-related entities of Colombia and Chile, the sovereign ratings of which were also lowered this year. (See tables 1 and 2 for a detailed list of fallen angels and rising stars.) In addition to the rising stars listed in table 2, consumer products company JDE Peet's N.V. was also upgraded to investment grade from speculative grade in May. However, as the company did not have rated debt instruments outstanding at the time of the upgrade, it is not included in this list.

Chart 12

Meanwhile, the increase in rising stars continues to reflect improving business conditions and beneficial mergers and acquisitions, led by the real estate, building materials, high technology, and oil and gas sectors. More specifically, all rising stars in the oil and gas sector were related to M&As, while those in the real estate and technology sectors were all related to strong operating performance.

Chart 13

The trend for rising stars is gaining some momentum, with the global number of potential rising stars increasing to 19. Of the potential rising stars, financial institutions, and metals and mining lead among sectors: the former because of improving economies and declining industry risk, and the latter owing to the rebound in commodity prices.

Chart 14

In contrast, the number of potential fallen angels globally is down to 65 and has consistently decreased since the record-high in mid-2020. In the U.S. and EMEA, there are 41 potential fallen angels remaining, from a peak of 73 at the worst of the COVID-19 shock. The reduced potential fallen angel debt over that period has been even sharper.

Chart 15

Chart 16

Historically, the large spikes in fallen angels during downturns tend to be followed by a more modest increase in rising stars during the subsequent recovery. With the current economic rebound supporting a faster-than-expected recovery in business conditions for many sectors, the slowing pace of fallen angels and increase in rising star activity is to be expected as the credit quality of 'BBB' issuers is on the mend.

Table 1

Table 2

Table 3

Table 4

Appendix 1: Hypothetical Scenario Analysis Approach

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 are assigned 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 each rating level ('BBB+', 'BBB', and 'BBB-') approximate the relative long-term fallen angel rates in the U.S. and EMEA regions combined over a 12-month rolling horizon from 2010 through 2020 (see table 5).

The risk weights applied to the negative and positive outlooks and CreditWatch statuses represent estimates for fallen angel potential given the current economic conditions--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. The risk weights applied to the stable outlooks reflect the downgrade rates that could be expected for that rating level given the average annual fallen angel rates since 2010, the average distribution of outlooks over that time period, and the risk weights applied to the negative and positive outlooks and CreditWatch statuses. We then multiplied the debt distribution by each corresponding risk weight in this scenario and summed the total. We used this to calculate a hypothetical downgraded debt amount through the end of 2021.

Table 5

Appendix 2: Additional Information

Table 6

Table 7

Table 8

Table 9

Related Research

• ‘COVID-19 Heat Map: Pent-Up Demand And Supply Shortages Further Improve Recovery Prospects For Credit Quality, June 8, 2021
• Orderly Global Reflation Will Support The Recovery From COVID-19, March 22, 2021