Since the summer of last year, North American corporate entities have reaped the benefits of highly favorable lending conditions, tapping capital markets awash with liquidity and setting issuance records. Based on S&P LCD, in 2021 (through Nov. 12), leveraged loan volume was about $576 billion, and high-yield issuance was over $445 billion. Both of these figures exceeded previous annual records and placed annual high-yield bond and loans volumes over the $1 trillion milestone for the first time (source: LCD U.S. loans research). These record financing volumes funded M&A transactions, pushed out maturities, reduced financing costs due to tightening spreads, and--in some cases--returned capital to investors with leveraged dividends.

Lately, most companies have benefitted from the strong pent-up consumer demand coming from high levels of savings. For the third quarter, based on FactSet data, of the 90% of the S&P 500 companies that have reported their earnings, 80% reported a positive EPS surprise. Moreover, leverage metrics for 12 of 16 sectors we track were the same or better than pre-pandemic levels (see "U.S. Leveraged Finance Q3 2021 Update: Leverage Is Getting Better (Almost) All The Time," Oct. 21, 2021).

The improved business performance, coupled with better balance sheets, made many issuers candidates for upgrades. For the first three quarters of 2021, we upgraded 289 North American speculative-grade corporate entities (excluding banks, financial institutions, and finance companies); this figure includes a few multiple upgrades. The pace and relative success of vaccinations have improved business conditions for COVID-19-affected sectors such as airlines and hospitality, with more people traveling this summer and staying at hotels. Based on Google's COVID-19 Community Mobility Reports as of October 2021, in-room dining is now only 8.6% below the pre-crisis level. In addition, passenger air traffic picked up in October after September weakness. And retail sales were healthy in October and should be solid this holiday season (see "Holiday 2021 Sales Outlook: Santa's Bag Is Filled This Holiday Season, Thanks To Deep Consumer Pockets," Nov. 23, 2021).

Oil and gas companies have also benefitted from the upswing in oil prices last year. Along with issuers in this sector, commodity producers in the metals and mining and homebuilding (lumber) segments benefitted from better cash flows and leverage based on the rebound of demand driving commodity prices.

Other subsectors continue to benefit from consumer demand for pandemic-heightened end markets. For example, RV (recreational vehicle) manufacturers, providers of home installation and servicing (such as pools), and specialty pet consumables retailers all benefitted, and we've upgraded many of these companies. Most rating actions have been within or into the 'B' category, which isn't surprising given this category's size.

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Key Reasons For This Year's Upgrades

Several reasons led to 120 speculative-grade issuers being upgraded to the next higher rating category in the first three quarters of 2021.

Sustainable capital structures sparked most upgrades to the 'B' category from 'CCC'.  In the first three quarters, we upgraded 71 entities into the 'B' rating category from the 'CCC' category. Ratings in the 'CCC' category typically reflect our view that the company's capital structure is unsustainable and is dependent on favorable business, financial, and economic conditions to meet financial commitments. Moreover, upgrades out of 'CCC' have ramifications for CLOs that have loans from issuers with ratings in this category, as they no longer have to take a haircut for overcollateralization tests when the number of 'CCC' rated enties exceeds the threshold specified in their documents. For the year so far, 48 companies with loans held in U.S. CLOs were upgraded out of the 'CCC' category.

Some key highlights among the upgrades out of the 'CCC' category:

• Nearly 40% of the upgrades, irrespective of the industry, stemmed from improved debt structures, where the company refinanced existing debt at reduced rates or deleveraged by using proceeds from noncore asset sales. There were also instances of companies raising funds via an IPO to reduce their debt, such as Petco Holdings Inc., Endeavor Operating Co. LLC, and Aveanna Healthcare LLC.
• Three sectors that took a significant hit last year--media and entertainment, restaurants and retail, and oil and gas--have recovered strongly and accounted for about 50% of the upgrades. The chemicals and packaging and capital goods sectors also had multiple companies with ratings raised out of the 'CCC' category.
• Pent-up demand, strong vaccination momentum, and improving customer confidence toward outside-the-home activities supported upgrades in the restaurants and retail industry. While some restaurants were quick to pivot to other sales channels like pick-ups and delivery, others streamlined their menus, and a few even benefitted from the closures of smaller competitors.
• Almost all the upgrades in the oil and gas exploration and production (E&P) industry were backed by an expectation and materialization of improving crude oil and natural gas prices. (WTI crude moved from $47.6/bbl in the beginning of the year to about $75/bbl by end of September.)
• Most of the capital goods and chemicals and packaging entities benefitted from the essential nature of their products or were helped by a rebound in end markets. For chemical companies, the ability to pass the increases in raw material prices helped improve business performance.

Upgrades to the 'BB' category from 'B'.  During the first three quarters of 2021, we raised 36 ratings out of the 'B' category into the 'BB' category. These upgrades affected multiple sectors, with restaurants and retail leading the list, followed by health care.

Some key highlights among the upgrades into the 'BB' category:

• While pent-up demand and strong vaccination rates were the key drivers for restaurant upgrades, those in the retail and media and entertainment industries were driven by higher demand for outdoor exploration and sports-related hobbies (including pool installations) given consumers' focus on outdoor living amid pandemic restrictions and improved confidence due to the broader economic recovery.
• Entities in the health care industry deleveraged using their free cash flow. And one upgrade resulted from an acquisition by a higher-rated peer.
• Homebuilders and real estate companies demonstrated strong volume-based sales growth in both affordable and higher-margin housing units, partly supported by low interest rates and consumer demand shifts driven by remote work during the pandemic (source: "Remote Working, Commuting Time, Life Events All Affect Home Buyers' Decisions," U.S. Census Bureau).

Breaking into investment grade.  Some key highlights among the upgrades into the 'BBB' category:

• This year, 15 North American ratings were rising stars, which means the ratings moved to investment grade ('BBB-' and higher) from speculative grade ('BB+' and lower). Upgrades to the 'BBB' category were dominated by issuers in high-tech, homebuilding/real estate, and oil and gas.
• Acquisitions of speculative-grade companies in the oil and gas E&P, forest products, and high-tech spaces by higher-rated investment-grade peers triggered multi-notch upgrades.
• Upgrades in the homebuilder sector stemmed from strong demand for housing (supported by lower interest rates), robust sales growth, and better cash flows, which have led to strong operating margins as well as improved cash positions and leverage.
• In the technology sector, strong revenue--coupled with management commitments to maintain a conservative balance sheet and financial policy as well as low leverage--supported upgrades. Other upgrade reasons were issuer-specific and included sustained EBITDA margin expansion coupled with market share gains, entry into a Top Three market position with high barriers to entry (due to the complex nature of product design), a track record of solid business execution, and the spin-off of a significant software division supporting debt reduction.
• A large container lessor was bolstered by better refinancing terms, market leadership, and excellent fleet utilization at higher lease rates, with demand expected to continue exceeding the supply of cargo containers.
• A major nitrogen-based fertilizer producer benefited from significant debt paydowns and management focus on further deleveraging, along with strong operating performance driven by its large scale and cost leadership.

While companies have benefitted from significantly improved lending conditions and benign market conditions, those with lower speculative-grade ratings have increased their exposure to financial risk through increased debt and higher leverage. Further, the risk of sustained inflation and the ability of a company to pass on costs to consumers will put pressure on their ability to service debt and generate cash flows. Investors' collective sentiment on risk and return remains a critical underpinning of the market's current acceptance of leveraged credits.