Rising stars (issuers upgraded to investment-grade from speculative grade) continue to outnumber fallen angels (issuers downgraded to speculative grade from investment-grade) so far in 2021, as the economic rebound in the U.S. and Europe continues to support business conditions. However, the pace of improvement is showing signs of moderating, as fallen angels outnumbered rising stars in the third quarter. While 'BBB' nonfinancials have benefited from plentiful cash and extremely favorable financing conditions, these attributes set the stage for more potential mergers and acquisitions that could slow the pace of credit quality improvement. Although M&A has led to a mix of downgrades and upgrades of 'BBB' issuers this year, a growing volume of M&A deals could lead to renewed credit weakening, particularly if deals signal increasingly aggressive financial policies.

Fallen Angel Debt Is Estimated Around $100 Billion

For our hypothetical scenario in this report, we estimated the amount of long-term nonfinancial corporate 'BBB' category rated debt vulnerable to being downgraded to speculative grade over the next 12 months in the U.S. and EMEA by assigning fallen angel probabilities to each rating and outlook or CreditWatch combination as of Aug. 31, 2021. These hypothetical relative probabilities and the approach used to generate the estimates are summarized in table 5 in the Appendix. The estimated results were as follows:

• We estimate that about $100 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 $68 billion, or about 2.2% of the outstanding total long-term 'BBB' debt on Aug. 31.
• From EMEA, this includes around $32.2 billion, or 1.5% of outstanding nonfinancial 'BBB' debt.

There has been $24.7 billion in debt associated with nonfinancial corporate fallen angel downgrades in the U.S. and EMEA in 2021 through September. While our estimate of fallen angel debt is markedly higher than this year-to-date total, it represents about 57% of the debt associated with potential fallen angels (issuers rated 'BBB-' with either a negative outlook or CreditWatch), which show elevated risk of downgrade to speculative grade.

Chart 1

The number of potential fallen angels (and their associated debt) has steadily declined since reaching a high in the summer of 2020. As of the end of September, there are 28 nonfinancial potential fallen angels in the U.S. and EMEA with close to $177 billion in associated debt, back near the levels from the end of 2019 (see chart 2). By contrast, there are fewer nonfinancial potential rising stars (issuers rated 'BB+' with either a positive outlook or CreditWatch) in the U.S. and EMEA (with 14), and these issuers have less associated debt (with about $79 billion).

Chart 2

Since May 2021, the outstanding debt of U.S. and EMEA nonfinancial potential fallen angels decreased by nearly $40 billion, with $31 billion of the decrease due to favorable outlook revisions to stable or positive (see chart 3). However, the pace of the improvements appears to be moderating in recent months. More than 70% of this decrease in potential fallen angel debt over this period occurred in June and July.

Chart 3

Conditions Are Ripe For Rising M&A

M&A activity has come back strong as the economic rebound has taken hold.

Accommodative financing conditions and low funding costs may continue to fuel elevated M&A activity.   The number of M&A deals (of $500 million or more, regardless of whether the target was rated) jumped to about 250 in fourth-quarter 2020 (up 66% over the prior quarter), and the quarterly numbers have since continued to rise. Accommodative financing conditions are providing plentiful funding while 'BBB' bond yields remain near record lows. Furthermore, elevated inflation measures in recent months imply a negative real yield on 'BBB' bonds, and the possibility of borrowing at negative rates further incentivizes future deals with debt financing (see chart 4).

Chart 4

Among 'BBB' issuers, cash is plentiful and financial policies are generally looser than in 2020.   In 2020, investment-grade issuers raised record levels of debt to fund operations and build cash reserves as the pandemic-related slowdown spread. For many companies, the business impact of COVID-19 was not as damaging as initially expected, and the incremental cash raised remains on balance sheets. This cash presents a considerable stockpile of dry powder that could be used to pay extraordinary dividends or pursue acquisitions. 'BBB' issuers' aggregate cash levels have been growing over the past 15 years as the number of 'BBB' issuers has nearly doubled. Companies appear to have begun drawing down from this cash after reserves reached a peak in 2020, and we estimate that 'BBB' nonfinancials in the U.S. and EMEA still have over $1.1 trillion in cash on their balance sheets (see chart 5).

Chart 5

'BBB' borrowers are especially sensitive to large, debt-financed acquisitions, which can potentially trigger a downgrade--sometimes to speculative grade. Even cash-funded acquisitions can weaken credit metrics when they reflect a change to a more aggressive financial policy. This is not to suggest that all M&A transactions are negative for credit. Some can result in an upgrade if the deal does not materially weaken the financial risk profile and the combination benefits the new group's business risk profile.

Aside from a downgrade, we could affirm the rating of the buyer if we expect the financial profile of the new entity to fully recover, usually within about two years after the deal closes and following a temporary deterioration in credit metrics. Many of the transactions that 'BBB' issuers closed in the last few months fell under this category.

One recent example is the proposed merger of Discovery Inc. with Warner Media in May 2021. After the announcement of this $43 billion bid for Warner Media, we affirmed Discovery's rating at 'BBB-', as the combined entity would be the second largest global media company and the merger would also address Discovery's existing business risks of smaller scale and narrow content. However, the practical execution of this deal remains the main risk that could pressure the rating. Should synergies not materialize and profit growth and cash generation fall short of expectations, then the new entity's credit metrics may fall below those consistent with the 'BBB-' rating.

M&A Has Already Contributed To Several Fallen Angels In 2021…

One of the most recent M&A-related fallen angels is Perrigo, a Dublin-based global consumer self-care company, which announced its plan to acquire the French self-care company Héra SAS for $2.1 billion. Following the announcement, we lowered Perrigo's rating by two notches to 'BB' from 'BBB-', as we believed Perrigo's use of existing cash and new debt to finance the acquisition would lead to deteriorating credit metrics that would not be offset by the increase in scale and products.

Through September of this year, M&A has led to six fallen angels. These fallen angels include G4S PLC from the consumer products sector and Standard Industries Inc. from the forest products and building materials sector. Downgrades we considered to be M&A-related also include those that followed a divestiture or a spinoff that resulted in lowered credit quality, such as through reduced scale or diversification.

In addition to the downgrades that followed specific M&A announcements, Host Hotels & Resorts' downgrade was indirectly related to M&A. While Host Hotels was not downgraded due to an announced acquisition, its downgrade followed management's characterization of the company's cash reserves as a strategic advantage for making opportunistic acquisitions, and we thought this shift in financial policy could increase net leverage.

Chart 6

…While Other M&A Deals Have Boosted Rising Stars

Acquisitions can be also be positive for credit, even if these cases are less common.   Take, for example, the recent acquisition of U.S. biopharmaceutical group Alexion by AstraZeneca. We upgraded AstraZeneca's 'BBB+' rating to 'A-' because the acquisition stands to increase the group's penetration into the profitable disease market, and most of the purchase price was financed by the issuance of new shares, significantly reducing the potential negative impact on AstraZeneca's financial risk profile.

One of the most recent M&A-related rising stars, Dell Technologies Inc.'s issuer credit rating was raised to 'BBB' from 'BB+' on Sept. 29, 2021, as it remains on track to complete its planned spinoff of VMware Inc. by early November and as its financial performance has been better than we anticipated due mostly to continued PC strength. While Dell is the largest issuer to become a rising star so far in 2021, much of Dell's rated debt was already investment-grade prior to the upgrade.

Through September of this year, mergers and acquisitions have led to eight of the upgrades for rising stars. These M&A-related upgrades include all four from the oil and gas sector, as each was either acquired by, or merged with, a higher-rated entity (see chart 7).

Chart 7

Financing Conditions Present A Window Of Opportunity For Deal-Making

COVID-19 has led to the acceleration of structural changes that were already underway in some sectors. Some companies are pursuing M&A deals to speed their adaptation. In the energy sector, the transition to renewable energy is redefining strategic priorities, just as the pharmaceutical industry is rapidly applying recent COVID-related advancements to new fields, and the consumer and retail sectors are adapting to consumers' changing habits and behaviors.

In this context, extremely accommodative financing conditions in the credit markets this year are supporting the rising levels of M&A activity. Funding costs remain low, and many companies are pursuing acquisitions that they are trying to close before the Federal Reserve begins tapering and ahead of potential tax increases in the U.S.

'BBB' funding costs continue to hover near their all-time low, and this cheap funding provides opportunities for strategic investments. 'BBB' bond yields averaged 2.4% in August, which is less than half the long-term average and below recent U.S. inflation measures (see chart 8). In July and August, 'BBB' spreads were largely unchanged, widening by just 6 basis points (bps) from their all-time tightest point at the end of June (see chart 9).

Chart 8

Chart 9

With the 'BBB' spread this narrow, the funding cost of a notch (between 'BBB-' and 'BB+') has fallen by 13 bps so far in the third quarter, and is just slightly more narrow than the long-term average cost of a notch (see chart 10). With such an incremental risk premium, companies may be tempted to risk adopting more aggressive financial policies that could lower credit quality or potentially lead to a downgrade.

Chart 10

While we don't expect to see a rush of companies pursuing transactions that would lead to downgrades, we are beginning to see that companies are willing to adopt more aggressive financial policies involving existing cash or new debt. Where these policies contribute to weaker credit metrics, they leave companies less prepared to weather the next unexpected shock or downturn.

So far this year, 'BBB' category bond issuance is down 44% in the U.S. and down 18% in Europe (see charts 11 and 12). Record issuance volume in 2020 makes for difficult comparisons year-over-year, but 2021 issuance so far is outpacing the volume from 2019 in both the U.S. and EMEA. After an even slower-than-normal August, investment-grade issuance rebounded in September, setting a new one-day record in the U.S. on Sept. 7, following a holiday weekend. Looking forward, many bankers are reportedly expecting heightened issuance volumes through the end of 2021 as companies try to lock in rates in advance of the Fed's eventual tapering.

Chart 11

Chart 12

Credit Trends Remain Favorable, But With A More Balanced Mix Of Fallen Angels And Rising Stars

Credit trends for issuers in the 'BBB' category as well as crossover credits remain favorable, even if the pace of improvement is moderating. Rising stars continue to outnumber fallen angels so far in 2021 (by 20 to 11 for nonfinancials in the U.S. and EMEA). By dollar amount, rising star debt exceeds that of fallen angels by $133 billion year-to-date for nonfinancials in the U.S. and EMEA (see chart 13).

However, fallen angels outnumbered rising stars in the third quarter (six to five), and the number of fallen angels equaled that of rising stars over the last two months. There were five nonfinancial fallen angels in the U.S. and EMEA in August and September, including Resorts World Las Vegas LLC, Genting New York LLC, Carpenter Technology Corp., Entergy New Orleans LLC and Perrigo Co. PLC. This equaled the number of rising stars over the same period

Chart 13

The pace of improvement in 'BBB' credit quality has diverged in the U.S. and EMEA in recent months. The trailing 12-month downgrade rate of 'BBB' nonfinancials has ticked modestly higher in the U.S. (up to 4.5%), even as the downgrade rate in EMEA continued its decline (falling to 1.67%). However, both downgrade rates are down compared to last year (see chart 14).

Chart 14

While the pace of downgrades has diverged, outlooks continue to point toward fewer downgrades on the horizon from the 'BBB' category. Negative bias (issuers with a negative outlook or CreditWatch) has fallen in recent months for the 'BBB' category, down by two percentage points in the U.S. and down by four percentage points in EMEA (see chart 15).

Chart 15

Overview Of Global Potential Fallen Angels And Rising Stars

Globally and across financial and nonfinancial sectors (excluding sovereigns), the number of potential fallen angels fell to 46 in September, from 65 at the end of May (chart 16). Close to $232 billion in debt is associated with potential fallen angels, and the sectors with the largest amounts of associated debt include aerospace and defense (with $61 billion) and media and entertainment (with $48 billion). While Boeing Co. accounts for nearly all of the potential fallen angel debt associated with the aerospace and defense sector, the debt from the media and entertainment sector is more widely split among nine issuers (see chart 17).

Chart 16

Chart 17

Although the number of potential rising stars globally remains below that of potential fallen angels, the gap continues to narrow. The number of potential rising stars is up to 25 in September, from 19 at the end of May (see chart 18). Nearly $111 billion in debt is associated with potential rising stars (including financial services), with the largest amounts of associated debt in health care (with $37.6 billion) and consumer products sectors (with 21.9 billion). The largest potential rising stars include HCA Healthcare Inc., Netflix Inc., JBS S.A., and Newell Brands Inc. (see chart 19). Note that when we base these amounts on the debt potentially affected by a rising star upgrade (or fallen angel downgrade), we include all rated debt of an issuer.

Chart 18

Chart 19

Table 1

Table 2

Table 3

Table 4

Appendix 1: Hypothetical Scenario Analysis Approach

This hypothetical scenario analysis includes 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 includes secured and unsecured bank loans, subordinated debt, medium-term notes, preferred stock, convertible debt, and drawdowns under medium-term note programs. It does 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 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 each rating level reflect the downgrade rates that could be expected for that rating level given the average annual fallen angel rates since 2010, adjusted for 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 over the next 12 months.

Table 5

Table 6

Table 7

Table 8

Table 9

Table 10

Related Research

• Dell Technologies Inc. Upgraded To 'BBB'; Outlook Stable On Improved Financial Profile Following Expected Spin-Off Of VM, Sept. 29, 2021
• Perrigo Co. PLC Downgraded Two Notches To 'BB' On High-Multiple Acquisition; Outlook Stable, Sept. 10, 2021
• Credit Trends: 'BBB' Pulse: Two Fallen Angels Were Downgraded In July Amid A Lull In Rising Stars, Aug. 25, 2021
• Credit FAQ: Consequences Of And Lessons Learned From The AT&T-WarnerMedia-Discovery Transaction, May 25, 2021