The Russia-Ukraine conflict and the spate of financial and economic sanctions that followed are contributing to significant volatility in capital markets, leading to a diverging impact on 'BBB' issuers in the U.S. and EMEA. Not only have credit trends recently diverged between these regions, but so too has the impact on companies' credit risk from risk factors such as rising energy prices, Russian exposure, and macro risks including interest rates and inflation.

Paths Diverge Between Fallen Angels In EMEA And Rising Stars In The U.S.

There were 14 fallen angels globally in first-quarter 2022. Of these, 13 were downgraded after the invasion of Ukraine in mid-February. Notably, 12 of these were from EMEA, specifically Russia. We downgraded these Russian entities, including the sovereign, following the announcement of sanctions that limited the government's access to its foreign exchange reserves. With these Russian downgrades, the 'BBB' downgrade rate in EMEA jumped to 7.2%, even as it dipped to 1.5% in the U.S. (see chart 1).

Chart 1

Although the onset of the conflict and sanctions brought an increase in financial market volatility and downgrades of Russian entities, this did not deter an uptick in rising stars (issuers upgraded to investment grade from speculative grade) during the first quarter. Notably, all nine of these rising stars were U.S.-based entities.

The amount of debt associated with nonfinancial corporate fallen angels in the U.S. and EMEA more than doubled to $77.6 billion in the first quarter, exceeding the full-year 2021 fallen angel total of $32.0 billion. Most of the downgraded amount reflected the sharp turn in Russian credit quality following the beginning of the war and the rollout of sanctions.

Fallen angel debt modestly exceeded the debt of rising stars in the first quarter, reversing the trend from 2021 when the debt of rising stars had been surpassing that of fallen angels(see chart 2).

Chart 2

So Far, The Conflict's Ratings And Market Impact Appears Contained

So far, the fallen angel downgrades appear to be contained to those entities closest to the conflict. Through first-quarter 2022, all of the issuers that were downgraded as a result of the conflict were Russian. And by the end of March, no Russian entities remained rated in the 'BBB' category. Those that remained rated were all in the 'CCC'/'C' category, and those ratings were subsequently withdrawn in April.

The number of potential fallen angels (issuers rated 'BBB-' with negative outlooks or CreditWatch placements; PFA for short) continues to decrease globally. While three issuers were added to the list of PFAs during the quarter, none of these additions were related to the Russia-Ukraine conflict.

In the U.S. and EMEA, the number of PFA issuers declined to a historic low in the quarter, while the amount of debt associated with PFAs further declined (see chart 3). Two-thirds of the decrease in PFA debt resulted from outlook revisions to positive or stable (see chart 4).

Chart 3

Russia-Ukraine Conflict Has Minimal Impact On Our Estimate Of Fallen Angel Downgrades Over The Next 12 Months

While we see that credit market risks are growing, we do not expect fallen angel downgrades to continue at same rapid pace of the first quarter. No Russian entities remain in the 'BBB' category, PFA debt showed a modest decline, and the recent increase in the 'BBB' negative bias in EMEA is partially offset by a decline in that of the U.S.

Our estimate of the amount of fallen angel debt over the next 12 months has increased only modestly since the beginning of 2022. In our current estimate, we project that fallen angel downgrades will approach $95 billion over the next 12 months (see chart 5). This estimate is up from $87 billion in our prior-quarter estimate. This downgrade estimate represents about 1.72% of total 'BBB' nonfinancial debt in the U.S. and EMEA. The increase in the fallen angel estimate is relatively more pronounced for EMEA than for the U.S. since the conflict suggests more uncertainty, and potentially nonlinear risks, for issuers in EMEA.

Chart 5

For the U.S., this estimate includes roughly $61.0 billion, or about 1.75%, of the outstanding total long-term 'BBB' debt as of March 31, 2022. This estimate is up just slightly from the 1.70% in our prior-quarter estimate.

For EMEA, this estimate includes about $33.9 billion, or 1.65% of outstanding nonfinancial 'BBB' debt. This share of debt at risk of downgrade to speculative grade in EMEA has risen from 1.3% in our prior estimate and is now much more closely in line the U.S. Among other factors, this also reflects the increase in the negative bias for EMEA 'BBB' nonfinancial issuers relative to those in the U.S.

Ratings biases among 'BBB'-category credits are also pointing toward this slight divergence across the two regions. The negative ratings bias in the U.S. trended to 8.3% at the end of March, down from 10.2% at year-end 2021. In EMEA, the negative bias had seen relative stability, holding near 8.5% from November 2021 through February 2022, only to shoot up to 11.7% in March (see chart 6).

Chart 6

Potential For Fallen Angels And Rising Stars Shows A Regional Tilt

Of the 37 global PFAs as of March 31, only nine were U.S. nonfinancial companies versus 13 for EMEA. As for PFA debt, U.S. nonfinancial companies have more with $80.7 billion as opposed to EMEA's $45.8 billion, but $58 billion of U.S. PFA debt is concentrated from just one issuer: Boeing (see chart 7 and table 3).

Of the 34 global potential rising stars (issuers rated 'BB+' with positive outlooks or CreditWatch placements; PRS for short) 15 are nonfinancials from the U.S. compared with seven from EMEA (see chart 8).

Meanwhile, all nine rising stars this year are from the U.S., including three financial institutions and six nonfinancial companies. These rising stars also include two round-trippers (issuers that became fallen angels in 2020 and were subsequently upgraded back to into investment grade), Kraft Heinz and EQT. Notably, Kraft Heinz is now showing stronger credit quality than before its downgrade to speculative grade in 2020 because the company has reduced its net debt by about $8.5 billion since 2019.

Risk Factors Are Diverging Between U.S. And EMEA

Besides relative differences in credit trends, there is also a divergence in risks facing 'BBB' corporates across the U.S. and EMEA.

Energy And Input Prices

In EMEA, the most-immediate negative effects on corporates from the Russia-Ukraine conflict are rising energy and input costs, especially in metals and agricultural products. The greatest affect so far is from the remarkable increase in natural gas prices. Some 40% of the gas used in EMEA is imported from Russia, and Germany and Italy are the countries most exposed.

The impact of these energy and input cost increases in EMEA may not soon subside. Price hikes are flowing gradually through companies' cost structures since many supply contracts are based on periodic price reviews. Although these may lessen the impact of price spikes in the short term, this may also prolong the effect of higher prices.

By contrast, the U.S. energy sector has capitalized on its position as a net exporter. Energy producers are benefitting from rising commodity prices, and some are also stepping in to fill the void resulting from supply disruptions.

Aside from energy prices, consistency of supply also matters. Potential natural gas supply disruptions present a further risk to EMEA companies. The utility sector is most directly exposed to gas price volatility and supply disruptions. We have already placed 'BBB' rated utilities companies, Fortum Oyj and Uniper SE, on CreditWatch negative due to the risk of disruption to gas imports having significant financial effects. Existing hedging positions may heighten this risk because many require margin postings that significantly increase liquidity needs. While we find it likely that severe disruptions in the gas supply would probably trigger government-support interventions, it's too soon to make assumptions how these interventions could make, or the potential support they could provide to the ratings.

Exposure to Russia

A secondary negative effect is related to how much direct exposure an issuer has to business in Russia. Two examples of EMEA issuers from the 'BBB' category are Technip Energies N.V. and Coca Cola HBC AG. Technip is a France-based engineering and construction and technology company that had 23% of its backlog exposed to Russia in December 2021. As a result, we lowered the rating to 'BBB-' from 'BBB' to reflect the expected contraction in the business. Similarly, Coca Cola HBC AG is a Switzerland-based beverage manufacturer that had a 20% EBIT exposure to Russia and Ukraine in 2021. In this case, we revised the outlook to negative, while affirming the rating at 'BBB+'.

A related negative effect is where companies choose to stop or suspend their operations in Russia. These decisions carry costs related to the dismissal of local assets and workforce. So far, we have not taken any rating actions directly related to this issue, but we believe that the full reckoning of these costs might take some time to evaluate.

Meanwhile, U.S. companies have shown much less exposure to Russia. So far, no U.S. 'BBB' category issuer has been downgraded, or had an outlook revised, due to such exposure. For the most part, the impact of the Ukraine conflict on U.S. markets has been reframed as a broader geopolitical risk, which becomes more of a factor only if the sanctioned nations list grows to include larger neighboring economies or more countries become directly involved in military operations.

Macroeconomic risks: Inflation and interest rates

In the U.S., the focus of market concerns has shifted from the Russia-Ukraine conflict mostly to macroeconomic factors including inflation, and what it might imply for the pace of increase in the Fed Funds rate.

After U.S. spreads initially bounced wider at the onset of the war, they've since narrowed, approaching preconflict levels. The differential in spreads between 'BBB-' and 'BB+', or the marginal cost of a notch downgrade into speculative-grade, has also tightened in recent weeks.

Chart 9

Chart 10

While our economists forecast above-trend U.S. real economic growth of 3.2% in 2022, we also anticipate that rising interest rates, price inflation, and the sunsetting of government support programs will reduce consumer spending and temper economic growth to closer to 2.1% in 2023.

Even with these economic headwinds, 'BBB' category issuers should generally have ample access to capital markets, although at higher funding costs. In addition to higher risk-free rates, inflation sensitive or consumer facing sectors, like restaurants and retail could face higher risk premiums.

By contrast, inflation has been lower in Europe--and a less-pressing concern. Europe's growing labor force and declining structural unemployment have made the labor-market more inflation-resistant to date.

But the conflict stands to exacerbate inflationary pressures and hurt the economic recovery in Europe--especially given its proximity to the conflict and its reliance on Russian commodity exports. Energy-intensive sectors will be hit sooner and heavier by the current situation. Ultimately, if a sudden increase in inflation reduces consumers' discretionary spending, the impact will be broad, potentially affecting many sectors.

Mitigating the risk of rising costs, we note that many EMEA companies in energy-intensive sectors such as chemicals, metals, and building materials have established solid financial risk profiles from very strong performances reported in 2021. This should help them accommodate the ongoing pressure from increased costs. Furthermore, we expect margin pressures to be only temporary for such companies with solid market position and business risk profiles, which should eventually be able to pass-on cost increases to customers.

Financing Conditions Remain Supportive For 'BBB' Credit--In Both The U.S. And EMEA

Turbulence in the equity markets and slowing demand for leveraged finance issuance in the first quarter does not appear to be deterring investors from new issue 'BBB' debt in either the U.S. or EMEA. Even with bond yields of newly issued 'BBB' bonds rising with expectations for higher interest rates, 'BBB' issuance volumes increased in the first quarter. Unlike the leveraged finance market, we expect the current transition from LIBOR to SOFR to have little impact on 'BBB' category issuers, since floating-rate loans account for a very small share of 'BBB's debt capital structure.

Chart 11

Chart 12

Even though the initial credit impact of the conflict has been largely contained, a more prolonged, or broader, struggle heightens uncertainty for corporate credit. 'BBB's have shown resilience to the challenges faced so far, and capital markets have continued to provide ample funding for 'BBB's. But issuers are facing risks on multiple fronts including the conflict, economic sanctions, supply chain disruptions, rising inflation expectations, and interest rate hikes. Though 'BBB' paths may have diverged between the U.S. and EMEA in the first quarter, these credit risks continue to loom over both regions.

Appendix

Chart 13

Chart 14

Table 1

Table 2

Table 3

Table 4

Hypothetical Fallen Angel Downgrade 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 February 2022 (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 weight for companies rated in the 'BBB' category 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

Related Research

• Coca-Cola HBC AG Outlook Revised To Negative On Weaker Credit Metrics From Russian Business Suspension; Ratings Affirmed, March 17, 2022
• Fortum And Uniper 'BBB' Ratings Placed On CreditWatch Negative On Exposure To Russia-Ukraine Conflict, March 14, 2022
• Technip Energies Downgraded To 'BBB-' On Likely Loss Of Russian Project; Outlook Stable, March 11, 2022
• Kraft Heinz Co. Upgraded To 'BBB-' On Operational Improvements, Debt Ratings Raised; Outlook Positive, March 11, 2022
• A Deep Look At Europe's Stronger, Smoother, And More Inflation-Resistant Labor Market, Feb. 28, 2022