Downgrade Risk Ebbs Across Most Sectors

Fewer U.S. companies were at risk of downgrade at the start of 2022 than in any year since 2015. At 13%, the U.S. corporate negative bias (the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications) is more than 20 percentage points lower than it was at the beginning of 2021, nine percentage points below its long-term average, and is just two percentage points above its all-time low. Negative bias continued its decline across most sectors in the fourth quarter of 2021, and now just three sectors show downgrade risk that is above their long-term average.

The combination of low interest rates, exceptionally favorable financing conditions, and above-trend economic growth contributed to a remarkable improvement in credit quality in 2021, exemplified by the record number of upgrades. However, that pace of improvement will be hard to match in 2022, especially as issuers grapple with inflation, supply chain disruptions, and geopolitical risk, while the specter of rising interest rates looms.

Chart 1

With a negative bias of 29%, the aerospace and defense sector enters 2022 with the highest downgrade risk of U.S. sectors. This sector also shows a negative bias that is highest above its long-term average (of 19%). Despite the elevated negative bias in this sector, we're seeing signs of improvement as air traffic is picking up in some large domestic markets globally, boosting demand for aircraft, and the sector's negative bias fell by 10 percentage points in the fourth quarter of 2021.

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The consumer products sector has the second highest negative bias (at 21%), and this bias is worsening as the sector faces higher material and labor costs, coupled with supply-chain bottlenecks. The negative bias for the consumer products rose by 1 percentage point during the fourth quarter, and it was just one of the three sectors to show such an increase. However, recent ratings actions for the consumer products sector have been mainly positive, reflecting issuers' higher-than-anticipated resilience to the challenging operating conditions.

The sector with the largest increase in downgrade risk in fourth-quarter 2021 was homebuilders/real estate, as concerns of China Evergrande Group's liquidity spilled over to into capital markets. This risk of limited access to new capital market funding for other Chinese property developers is carrying into 2022. Several Chinese property developers are included within the data for U.S. corporate rating actions because they are incorporated in the Cayman Islands, which we group with the U.S. as a tax haven. Led by rising credit risk for Chinese property developers, the homebuilder/real estate negative bias rose 2 percentage points in the fourth quarter to 13%. Chinese developers continue to face declining sales volume and liquidity strains, even as those homebuilders in the U.S. market are benefitting from the brisk pace of sales in the U.S. that is supporting improving credit quality.

Meanwhile, rising hydrocarbon prices are contributing to a falling negative bias for oil and gas companies. This sector saw the steepest decrease in downgrade risk in the fourth quarter, as the negative bias dropped by 9 percentage points to 9%. Companies are taking the opportunity of higher oil and gas prices to reduce debt and repair balance sheets.

Besides aerospace and defense, only the health care and utilities sectors have negative biases that are above their long-term averages. Although in both cases the current negative bias is very close to its long-term average, with a difference of just 1 percentage point to 2 percentage points.

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Even though the negative bias is rising in a few sectors, overall downgrade risk continues to ebb for higher- and lower-rated companies alike. The negative bias fell by 2 percentage points for both speculative-grade (rated 'BB+' or lower) and investment-grade ('BBB-' and above) companies in the fourth quarter.

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At 14%, the speculative-grade negative bias is nearing its all-time low of 12% from 2014. Within speculative grade, the lowest rated category of 'CCC/C' shows the highest negative bias, at 62%, and yet even this rating category's negative bias is considerably lower than its 79% average of the past 10 years.

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Meanwhile, the investment-grade negative bias (at 12%) is back to its lowest level since before the pandemic. Within investment grade, the negative bias is highest for the 'A' category, which includes several issuers from the utilities sector (in which high capital spending has led to minimal financial cushions) and the consumer products sector (which face challenges posed by inflation and supply chain pressures).

Upgrade Potential Has Risen But Remains Near Average

The positive bias showed less of a change in the fourth quarter as the pace of upgrades also slowed. The speculative-grade positive bias was unchanged (at 11%), while the investment-grade positive bias rose by 1 percentage point to 7%. Both the investment- and speculative-grade positive biases are at their long-term average.

Eight sectors show upgrade potential above their long-term average, and this number is unchanged from the third quarter (see chart 8).

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The automotive sector has the highest positive bias at 21%, which is well above its long-term average of 11%. After recent earnings and cash flow improvements, both Ford Motor Co. and Tesla Inc. are now among the automakers with a positive outlook, and each are potential rising stars (issuers rated 'BB+' with either a positive outlook or ratings on CreditWatch positive). Tesla was also among the automotive sector upgrades during the quarter, as S&P Global Ratings raised its issuer credit rating to 'BB+'.

Meanwhile, the metals, mining, and steel sector continues to show above-average upgrade potential as it benefits from the boom in metals prices.

Pace Of U.S. Corporate Rating Improvement Appears To Be Slowing

The pace of upgrades slowed in the fourth quarter as the omicron variant of COVID-19 emerged and as higher-than-expected inflation started to weigh on consumer demand. After upgrades had already reached a new annual record in the third quarter of 2021, upgrades and downgrades were more balanced in the fourth quarter, with net upgrades (upgrades minus downgrades) dropping to their lowest level of the year (with 33).

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As net upgrades slow, rating levels are settling below pre-pandemic levels. During full-year 2020, net downgrades totaled 643 (excluding defaults). But even the record number of upgrades in 2021 has only lowered the cumulative number of net downgrades since the start of 2020 to 429 (see chart 10).

While the ratings distribution of U.S. corporate ratings (including financial and nonfinancial issuers) has been trending lower for years, the pandemic accelerated this trend. Currently, 20% of U.S. issuers are rated 'B-' or lower, and this share remains 3 percentage points higher than at the beginning of 2020. We expect these lower-rated issuers to be less resilient if confronted by a business, financial, or economic shock than their higher-rated peers, so this higher concentration of lower-ratings suggests issuers may be on weaker footing to weather the next shock (see chart 11).

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Downgrades Leveled Off During 2021

The pace of U.S. corporate downgrades leveled off through 2021. Downgrades fell to 43-45 per quarter in the second through fourth quarters from 57 in the first quarter. Downgrades continue to be highly concentrated among speculative-grade nonfinancials. There were just six investment-grade downgrades in the quarter, and three of these were fallen angels (issuers downgraded to speculative grade from investment grade). These fallen angels included Hyatt Hotels Corp. and specialty and packaging papers producer Domtar Corp, both of which were downgraded as a result of merger and acquisition activity.

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Table 1

Upgrades Move Up The Rating Scale

Upgrades were more concentrated among the lowest-rated issuers in the first part of 2021 than in the latter. While issuers rated 'CCC+' and lower accounted for 27% of upgrades in the second quarter, this share dipped to 17% in the third quarter, and 12% by the fourth.

Fourth-quarter upgrades were more concentrated in the 'B' category, as 47% of upgrades were of issuers rated 'B' or 'B-'. The 'B' category upgrades included 11 issuers from the media and entertainment sector, which is already highly concentrated within the 'B' rating category. These 'B' category media and entertainment upgrades included gaming companies and out-of-home entertainment companies that have shown faster-than-expected revenue and debt-reduction in 2021, and several of these companies had already been downgraded in 2020.

With upgrades moving up the rating scale, we also saw an uptick in 'BB' category upgrades, including five rising stars, in the fourth quarter (see table 3). The 'BB' category upgrades included both Netflix (now investment grade) and Tesla (now just one notch below investment grade). The 'BB' upgrades also included several rated subsidiaries of FirstEnergy Corp., which accounted for many of the utility sector's upgrades during the quarter.

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Table 2

Table 3

Credit Conditions Likely To Slow Growth Of Default Rate

Despite the positive credit trends for many companies, the number of defaults in the fourth quarter rose to nine from five in the third quarter. However, many of these fourth-quarter defaults were of the Chinese homebuilders that were incorporated in the Cayman Islands.

However, with the pace of downgrades slowing and with the negative bias dipping, default risk shows signs of moderating. The count of weakest links (issuers rated 'B-' and below with negative outlooks or on CreditWatch negative) fell to 131 in the fourth quarter from 160 in the third, pointing toward a decline in the number of issuers with the greatest risk of default. However, even as weakest links have declined, risks to Chinese developers remain. As noted in recent publications, we expect defaults for Chinese developers to increase over the next six to 12 months, and about one-third of the rated Chinese developers' liquidity could come under pressure under our most severe scenario stress test, according to our recent sensitivity analysis (see "China Property Watch: Strains In The Key Of 'B'," published Oct. 27, 2021).

Even though the number of defaults rose in the fourth quarter, the default rate in 2021 remained exceptionally low at just 1.5%. We expect the U.S. trailing-12-month speculative-grade corporate default rate to reach 2.5% by September. While this would be an increase from 2021, it would still be considerably lower than the long-term average of 4%. Above-trend economic growth, credit trends that have been more positive than negative, and remarkably favorable financing conditions have all contributed to the low default rate over the past year, and the continuation of these factors will likely continue to slow the growth of default rates.

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Table 5

Related Research

• Industry Top Trends 2022: Consumer Products, Jan. 25, 2022
• Industry Top Trends 2022: Oil and Gas, Jan. 25, 2022
• Industry Top Trends 2022: Aerospace and Defense, Jan. 25, 2022
• Industry Top Trends 2022: Homebuilders and Developers, Jan. 25, 2022
• Why China Property Firms Are Succumbing To Evergrande Effects, Nov. 18, 2021