Low default rates persist despite record levels of 'CCC' ratings.   The initial credit shock of the COVID-19 pandemic on the most vulnerable issuers was severe and fast, as the proportion of issuers rated 'CCC' and below ballooned to record highs. Most of the issuers downgraded at the beginning of the pandemic were seriously affected by health measures and social distancing protocols as both governments and societies responded to the global crisis. Despite the number of 'CCC' issuers spiking to record levels, speculative-grade default rates have not, peaking at half their levels seen in the 2008 financial crisis and then dropping rapidly.

Historically, there has been a strong correlation with the percentage of 'CCC' ratings and default rates.   Typically, more than a quarter of companies rated 'CCC' default within 12 months, spending on average 10 months in the rating category before defaulting. However, only 16% of companies rated 'CCC' as of July 2020 defaulted in the subsequent 12 months. This divergence between the percentage of 'CCC' ratings and default rates that occurred in the middle of 2020 is likely due to the abundance of government and central bank support, capital markets' fast rebound, and largely supportive owners--all providing a lifeline to corporate issuers. The low interest rate environment and appetite for yield has fueled speculative-grade issuance, which reached $508 billion in August as issuers at even the lowest rating categories have been able to borrow cheaply (see chart 3). Strong by historical standards, upgrades have largely outpaced downgrades in the 'CCC' space, and absent any external shocks to the market, we can expect to see the upward trend continue in the near term, temporarily weakening the relationship between the share of 'CCC' companies and the corporate default rate.

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Many business models will remain viable once the pandemic ends, and this should support rating normalization.   A large share of the downgrades to the 'CCC' category stemmed from our view of unsustainable balance sheets and deteriorated financial metrics. While it is in many cases too early to tell the long-term implications for some sectors of the economy, our assessments of the business risk profile (BRP) for these companies have largely remained unchanged globally so far, which could suggest a relatively rapid normalization of activity as restrictions fade away.

The profile of a typical 'CCC' rated company has changed in the past 18 months, reflecting the dramatic economic impact of COVID-19.   Before the pandemic, more than half of the companies within the 'CCC' category had a vulnerable BRP. Such companies are very small with a weak market position and intense competition, and they operate in secularly declining industries, such as print-based advertisers, certain brick-and-mortar retailers, etc. This number fell to 30% as of the end of the second quarter of 2021, as relatively stronger companies entered the category due to the material impact of the pandemic on their operations. This phenomenon is even more visible in the hardest-hit industries (leisure, transportation, retail, aerospace, oil and gas, and consumer services), which represent over 55% of the total number of 'CCC' rated companies and for which the share of these with a vulnerable BRP has halved since the pandemic.

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The pandemic's impact was largely business risk agnostic, but the recovery is not.   Because the 'CCC' rated companies now on average have stronger BRPs, this translates into unusually strong growth (see chart 7) and deleveraging (see chart 8 and 9) prospects, which should eventually support a positive transition out of the category. Although it is uncommon for 'CCC' rated companies to have strong deleveraging prospects, it reflects the uncertainty around our base case when it relies upon favorable business, financial, and economic conditions (end of travel restrictions, normalization of consumption habits).

Even so, the signs of stabilization--and, in time, recovery--from the 2020 downgrade wave are noticeable. Several companies were upgraded out of the 'CCC' category only a short time after being downgraded due to the pandemic. We distinguished three profiles of companies that have rapidly emerged out of 'CCC':

• Companies with relatively short maturities as COVID-19 hit, which were originally downgraded on refinancing risk before being upgraded as they successfully refinanced (see EnQuest, Tullow Oil, Kirk Beauty, McGraw-Hill Education, Urban One, Kenan Advantage Group). Other upgrades have been transaction-led, due to IPOs or mergers and acquisitions (M&A; see Petco Holdings, Endeavor Operating Co.).
• Companies that took steps to restructure their balance sheet in 2020, which triggered a default rating under S&P Global Ratings' criteria, were re-rated in the 'CCC' category, only to be upgraded later on as recovery prospects improved (see Rite Aid, Community Health Systems, SM Energy, Callon Petroleum).
• Companies with business fundamentals less severely affected than expected and benefitting from a rapid rebound (see Cengage Learning, Kronos Acquisition Holdings, LTI Holdings, Diamond (BC) B.V., GC EOS Buyer).

Chart 6

The pace of upgrades is likely to be driven increasingly by operating trends rather than financing conditions.   As the first two profiles of companies mentioned above are opportunity-driven and were allowed by the supportive financing conditions, we can expect the number of upgrades to gradually decline in the coming months as business performance becomes the main driver of rating actions. However, as shown in chart 10, it is customary for upgrades out of the 'CCC' category to take longer in the years following a major crisis (such as in 2001-2002 and 2010-2013) as uncertainties take time to dissipate, credit metrics improve, and the improvement is seen as sustainable.

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What's Next For 'CCC' Ratings And Default Rates?

Risk remains abnormally high despite the recent positive rating trend.   Within the leveraged finance sector, a crucial observation remains: leverage levels remain elevated for companies rated in the 'B' and 'CCC' categories, though the divergence between sectors and issuers arising from the pandemic persists. Financial market buoyancy and investor appetite for yield have supported issuers that benefited during the pandemic by pursuing debt-funded M&A or distributing dividends to their owners. By doing so, they passed on any uncertainty regarding their growth and profitability path firmly back in the hands of the lenders.

The divergence between 'CCC' rated entities as a percentage of all speculative-grade ratings and the default rate should fade away as government supports are withdrawn and financing conditions normalize.   Consequently, the convergence of the two figures could occur either if default rates caught up with the still-high share of 'CCC' ratings, or the other way around. The most likely scenario is somewhere in the middle. We expect that the combination of strong recovery prospects for 'CCC' rated companies and less supportive governments and financing conditions would lead the strongest companies to be upgraded and the weakest to default. While we don't expect it in the coming months, default rates could pick up temporarily as issuers are upgraded out of the 'CCC' category, until reaching a new equilibrium and reverting to the original behavior of moving hand in hand.

Related Research

• The Global Weakest Links Tally Reaches Pre-Pandemic Levels, Sept. 28, 2021
• Risky Credits: Upgrade Potential Is Highest Among U.S. Media And Entertainment 'CCC' Issuers, Sept. 16, 2021
• The Economic Impact Of Default Is Falling As Selective Defaults Rise, Sept. 16, 2021
• Growing Risks, Diminishing Rewards--Has The U.S. Speculative-Grade Market Hit A Peak?, Sept. 9, 2021
• Risky Credits: Europe's 'CCC' And Below Corporate Ratings Tally Remains Elevated, Aug. 2, 2021