(Editor's Note: This analysis is based on data as of May 31, 2023, so current conclusions may differ. In addition, this analysis focuses exclusively on pricing and rating data, and it does not account for regional or sectorial credit environments. The credit spreads in this report were calculated using the yields on U.S.-issued fixed-rate bonds with at least one year to maturity and a face value of at least $100 million.)
Key Takeaways
- The peak differential in credit spreads in absolute terms ('B' to 'B-') occurs just one step above an obvious pressure point: the downgrade into the 'CCC' rating category. This may imply that 'B-' (rather than 'CCC+') is the rating level at which markets materially increase default expectations.
- The cost of falling to, or close to, speculative grade remains very high, with the peak differential in spreads in percentage terms across all rating levels (27% for 'BBB' to 'BBB-') occurring a step above the downgrade to speculative grade.
- Despite the fact that becoming a fallen angel may mean sharply higher costs in percentage terms, the absolute cost is materially lower now, with a gap of only 64 basis points (bps) as of May 31, 2023--a stark contrast to the 284 bp differential at the start of the pandemic.
- Spreads on debt from issuers with negative rating outlooks are wider than the spreads on debt from similarly rated issuers with stable or positive rating outlooks. This could reflect the value of our corporate rating outlooks as reliable indicators of relative downgrade potential.
S&P Global Ratings' credit ratings correlate negatively with the cost of debt, meaning cost usually rises as ratings decline. Our corporate credit ratings are useful benchmarks in determining the margins over risk-free Treasuries that debt issuers pay to access the capital markets.
Chart 1
The peak differential in credit spreads in absolute terms ('B' to 'B-') occurs just one step above an obvious pressure point: the downgrade into the 'CCC' rating category (see chart 1). And the peak differential in spreads in percentage terms ('BBB' to 'BBB-') occurs a step above another obvious pressure point: the downgrade to speculative grade. These observations may imply that markets prepare for the worst and brace for impact ahead of time. But it is also evident that the market perceives falling to speculative grade as more costly in percentage terms.
Chart 2
Data suggests there's no clear correlation between a rise in the federal funds rate and the cost of becoming a fallen angel--an issuer downgraded to speculative grade from investment grade. That cost has also remained relatively stable in recent months despite the sharp rise in interest rates and the corresponding financing costs (see chart 2). However, this relative stability will be tested through the remainder of 2023 and through 2024 as the impact of monetary policy lags increasingly play through to markets and the wider economy and as rates are expected to remain higher for longer.
Chart 3
Unsurprisingly, higher-rated 'AAA'/'AA', 'A', and 'BBB' spreads historically trade at materially lower levels than speculative-grade spreads with lower rating.
That said, credit spreads at all rating levels consistently exhibit similar volatility trends in times of stress or market events, with the absolute levels reflecting the relative credit risk ranking (see chart 3). Despite the rising risks of higher rates, current spreads at the lower end of the rating spectrum are well below recent peaks.
The current cost of becoming a fallen angel is 77% below its peak from March 27, 2020, after the Federal Reserve announced that it would purchase investment-grade securities, as well as securities issued by more recent fallen angels. The current spread differential suggests that markets are not overly concerned about the impact of higher-for-longer interest rates on the economy or the prospect of increasing operating and financing pressures. It also suggests that markets may be pricing in less of a fallen angel risk premium.
Chart 4
Bonds from issuers rated 'BBB-' with a negative outlook trade around 42 basis points (bps) over bonds from similarly rated issuers with a stable outlook and around 105 bps over bonds from similarly rated issuers with a positive outlook (see chart 4). So, notwithstanding sector and regional factors, a 'BBB-' bond spread could differ by up to 150 bps depending on the rating outlook assigned. Furthermore, historical data indicates these gaps between spreads are more pronounced during recessions. Given the current uncertainty about the near-term macroeconomic landscape, we could see the gaps between these spreads widen markedly, should credit conditions deteriorate.
Chart 5
Bonds from 'BB+' rated issuers with a negative outlook carry, on average, an additional 103 bps over bonds from similarly rated issuers with a stable outlook and an additional 154 bps over bonds from similarly rated issuers with a positive outlook (see chart 5).
Related Research
- Credit Trends: 'BBB' Pulse: Rising Stars And Fallen Angels Pick Up Amid Economic Uncertainty, May 17, 2023
- Credit Trends: The Cost Of A Notch: During COVID-19, The Cost Of Falling To Speculative-Grade Reached A New High, April 14, 2021
- Credit Trends: The Cost Of A Notch, March 26, 2019
This report does not constitute a rating action.
| Credit Research & Insights: | Brenden J Kugle, Englewood + 1 (303) 721 4619; brenden.kugle@spglobal.com |
| Zev R Gurwitz, New York + 1 (212) 438 7128; zev.gurwitz@spglobal.com | |
| Patrick Drury Byrne, Dublin (00353) 1 568 0605; patrick.drurybyrne@spglobal.com | |
| Research Contributor: | Lyndon Fernandes, CRISIL Global Analytical Center, an S&P affiliate, Mumbai |
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