Credit ratings of U.S.-based, midsize companies within the S&P MidCap 400 index remained strong in the first quarter of 2012. Upgrades outpaced downgrades, and investment-grade companies outnumbered speculative-grade ones. During the first quarter, Standard & Poor's Ratings Services upgraded seven companies and downgraded four. However, in the next three months to two years, we expect potential downgrades to outnumber potential upgrades. Debt is an important source of funding for many of the companies in the S&P MidCap 400, which have $434.5 billion in total debt, compared with $1.2 trillion in market capitalization (as of March 31, 2012).

Standard & Poor's rates 60.3% of the S&P MidCap 400 index. Of the rated companies, 55% are investment grade ('BBB-' and above), and 45% are speculative grade ('BB+' and lower). These rated companies show a slightly stronger credit profile than the overall population of rated U.S. companies--the majority of which (51%) are speculative grade. In comparison, the majority of the rated companies from the S&P 500 are investment grade (86%).

(Watch the related CreditMatters TV segment titled, "Standard & Poor's MidCap 400 Index: The Key Credit Perspectives For First-Quarter 2012," dated April 9, 2012.)

For the first quarter, we note the following key points for rated companies within the S&P MidCap 400:

• Standard & Poor's downgraded the following companies: RadioShack Corp., Patriot Coal Corp., KB Home, and Harsco Corp.
• Standard & Poor's upgraded the following: Lamar Advertising Co., The Scotts Miracle-Gro Co., Hill-Rom Holdings Inc., Mohawk Industries Inc., Foot Locker Inc., Smithfield Foods Inc., and Kansas City Southern.
• Subsequent to the rating actions, stock prices of six of the seven upgraded companies outperformed the index, and all four of the downgraded companies underperformed the index.
• There is a greater likelihood that bond downgrades will outpace bond upgrades in the near to intermediate term, because we consider 24 companies to have the greatest risk of downgrade, compared with 18 that have the greatest potential for upgrades.
• Among investment-grade companies, there are 12 potential downgrades and 3 potential upgrades.
• Among speculative-grade companies, there are 12 potential downgrades and 15 potential upgrades.
• The sectors with the highest downgrade potential are the telecommunications services and consumer staples sectors. Of rated telecommunications companies, 50% (one of two) are at risk of downgrade, and 22.2% of rated consumer staples companies (2 of 9) are at risk.
• The sectors with the highest potential for upgrades are the energy and information technology sectors. Of energy companies, 13.3% (2 of 15) have the greatest upgrade potential, and 12.5% of information technology companies (3 of 24) have the greatest upgrade potential.

Table 1

Downgrade Risks Outweigh Upgrade Potential

Across the entire S&P 400, 10% of rated companies have a negative outlook or ratings on CreditWatch negative, which means that they are at the greatest risk of downgrades. Meanwhile, 7.5% of rated companies have a positive outlook or ratings on CreditWatch positive, which means these companies have the greatest upgrade potential. We assign positive or negative outlooks to issuer ratings when we believe that an event or trend has at least a one-in-three likelihood of resulting in a rating action over the intermediate term for investment-grade entities (generally up to two years) and over the shorter term for speculative-grade entities (generally up to one year). Standard & Poor's places a rating on CreditWatch if there is at least a one-in-two likelihood of a rating change within 90 days. Although these numbers suggest that credit quality may decline in the near to medium term, the outlook for S&P 400 companies is less negative than that of the U.S. corporate sector as a whole, which had a negative bias of 13.9%, compared with a positive bias of 7.3% at the end of March.

Of the rated companies within the S&P MidCap 400, the financials and utilities sectors have the strongest credit. Standard & Poor's rates 92% of financials and 88% of utilities investment grade. The energy and information technology sectors have the highest potential for upgrades. Within these sectors, 13.3% and 12.5%, respectively, of rated companies have positive outlooks or ratings on CreditWatch positive. On the flip side, the telecommunication services and consumer staples sectors have the greatest portion of its companies at risk of downgrade. Of the rated companies within these sectors, 50% and 22.2%, respectively, have either negative outlooks or ratings on CreditWatch negative. Also of note, the financial sector has a higher number of companies--five--that are at risk of downgrade, though this number represents only 8.5% of rated companies from the sector (for a complete list of potential downgrades and upgrades, see tables 6 and 7).

Within the first quarter of 2011, Standard & Poor's downgraded four companies from the S&P 400: RadioShack Corp. Patriot Coal Corp., KB Home, and Harsco Corp. Each of these companies has underperformed the S&P MidCap 400 since the individual rating actions (see table 2).

• Standard & Poor's lowered the rating on RadioShack Corp. one notch to 'B+' from 'BB-' on March 2, 2012, because of expectations of further weak performance.
• We lowered the rating on Patriot Coal Corp. one notch to 'B' from 'B+' on Feb. 10, 2012, as a result of weaker-than-expected demand.
• We lowered the rating on KB Home one notch to 'B' from 'B+' on March 27, 2012, because of weaker-than-expected first-quarter performance.
• We lowered the rating on Harsco Corp. one notch to 'BBB' from 'BBB+' on March 29, 2012, reflecting the company's delayed progress in restoring its historical profitability, its weakened cash flow protection measures, and our expectation that the company is unlikely to restore ratios adequate for a 'BBB +' rating over the next two years.

Table 2

Within the first quarter of 2011, Standard & Poor's upgraded seven companies from the S&P 400: Lamar Advertising Co., The Scotts Miracle-Gro Co., Hill-Rom Holdings Inc., Mohawk Industries Inc., Foot Locker Inc., Smithfield Foods Inc., and Kansas City Southern. Six of the seven companies have outperformed the S&P MidCap 400 since the day of the individual rating actions (see table 3).

• Standard & Poor's raised the rating on Lamar Advertising Co. one notch to 'BB-' from 'B+' on Jan. 26, 2012, following the company's continued progress in reducing leverage through debt repayment and modest EBITDA growth.
• We raised the rating on The Scotts Miracle-Gro Co. one notch to 'BB+' from 'BB' on Jan. 25, 2012, as a result of sustained improvement in the company's credit measures.
• We raised the rating on Hill-Rom Holdings Inc. one notch to 'BBB' from 'BBB-' on Jan. 10, 2012, reflecting our expectation that the company's mid-single-digit revenue growth will continue in fiscal 2012.
• We raised the rating on Mohawk Industries Inc. one notch to 'BBB-' from 'BB+' on March 14, 2012, and named the company a rising star. This upgrade reflects our view that Mohawk will maintain and improve credit metrics that are now consistent with a low investment-grade rating.
• We raised the rating on Foot Locker Inc. one notch to 'BB' from 'BB-' on March 21, 2012, reflecting our expectation for strong liquidity in the near term and the company's enhanced performance over the past year, which was ahead of our forecast as a result of recent merchandising improvements.
• We raised the rating on Smithfield Foods Inc. one notch to 'BB' from 'BB-' on March 27, 2012, reflecting our opinion that Smithfield's business risk has improved, in part because of better industry fundamentals, but also because we believe the company has adopted a more prudent approach to managing earnings volatility, including reducing its exposure to volatile agricultural commodity costs like corn.
• We raised the rating on Kansas City Southern (KCS) one notch to 'BB+' from 'BB' on March 27, 2012, reflecting KCS' stronger operating profitability, cash flow adequacy, and asset protection measures.

Table 3

Just as Mohawk Industries became a rising star in the first quarter, a few companies in the S&P 400 have the potential to move to investment grade from speculative grade, and vice versa. Six companies on the S&P 400 are potential rising stars, meaning Standard & Poor's could upgrade them to investment grade from speculative grade, which would likely lead to lower credit costs. These companies are: American Greetings Corp. (BB+/Positive/NR), Kansas City Southern (BB+/Positive/--), Superior Energy Services Inc. (BB+/Positive/--), Steel Dynamics Inc. (BB+/Positive/--), Cooper Cos. Inc. (BB+/Positive/--), and Lam Research Corp. ('BB+'/Watch Pos/--). On the other hand, four companies--Ralcorp Holdings Inc. ('BBB-'/CreditWatch Negative/--), Charles River Laboratories International Inc. ('BBB-'/Negative/--), Telephone and Data Systems Inc. ('BBB-'/Negative/--), and Universal Corp. ('BBB-'/Negative/NR)--are potential fallen angels, meaning that Standard & Poor's may downgrade them to speculative grade from investment grade.

Corporate funding costs rise considerably when moving down the ratings scale to speculative grade from investment grade. A broader mix of investors and institutions can buy and hold investment-grade bonds, so companies rated 'BBB-' and above typically borrow at lower rates than speculative-grade-rated companies. At the end of February, U.S. corporate bonds rated 'BB' had yields 1.8%--3.1% higher than the yields of bonds rated 'BBB'.

Table 4

Rated Companies On The S&P 400 Are Nearly Balanced Between Investment Grade And Speculative Grade

Just over half (55%) of rated S&P MidCap 400 companies are investment grade. These rated companies show moderately stronger credit than rated U.S. companies overall. Just less than half (49%) of all U.S. companies that Standard & Poor's rates are investment grade. However, the large cap companies from the S&P 500 have considerably stronger credit than the S&P MidCap 400. Of the rated companies from the S&P 500, 86% are investment grade (see chart 1). The median rating of the S&P 400 is 'BBB-'--one notch above the 'BB+' median rating for U.S. companies overall. The S&P 500 has a median rating of 'BBB+'--three notches above the median rating for U.S. companies overall. Standard & Poor's provides credit ratings for 241 (60.3%) of the companies within the S&P MidCap 400. A much higher portion (86%) of the companies in the S&P 500 are rated, which is not surprising, because this index cover the largest U.S. companies. In turn, just 21% of the small-sized companies from the S&P 600 are rated, and the majority of these rated companies are speculative grade.

Chart 1

As an alternative to looking at the distribution of ratings by number of companies, we also measured the distribution of the S&P 400 by market capitalization and total debt. 'BBB' is the largest rating category under all three of these measures (see chart 2). The 119 rated companies in the 'BBB' category from the S&P 400 represent $403.8 billion in market capitalization and $193.2 billion in total debt.

Chart 2

Total debt of the S&P 400 companies rose to $440.7 billion at the end of 2011 from $420.6 billion in 2010. As debt has risen, firms' cash holdings declined modestly to $109.9 billion from $113.3 billion (see chart 3). Because net debt, or debt minus cash, has increased slightly faster than EBITDA over the past year, the ratio of net debt has risen to 2.81x EBITDA from 2.77x in 2010. This amount of debt leverage falls between the median three-year average for 'BBB' and 'BB' rated U.S. companies. An increase in this ratio indicates decreasing capacity for debt repayment. Meanwhile, debt remained relatively stable as a proportion of assets, at 0.23 (see chart 4).

Chart 3

Chart 4

The nonfinancial companies that Standard & Poor's rates more highly tend to be larger in terms of market capitalization and total enterprise value compared with lower-rated entities. Total enterprise value is the combined value of the firm's debt plus equity, minus cash and short-term investments. 'B' rated companies have an average market capitalization less than half of 'A' rated companies, while average total enterprise value of 'A' rated companies is 42% higher than that of 'B' rated companies (see table 5).

Table 5

Surprisingly, companies Standard & Poor's does not rate show many average credit measures comparable with those of highly rated entities. The companies that are not rated have aggregate debt-to-debt-and equity and total-debt-to-EBITDA measures that are similar to the averages of investment-grade companies. Partially, this is because of a selection bias. Some of the largest unrated companies within the S&P MidCap 400, such as Monster Beverage Corp. and Regeneron Pharmaceuticals Inc., have more cash than debt on their balance sheets.

A note on the methodology: we have used financial measures from S&P Capital IQ for the charts and tables within this report. Standard & Poor's Ratings Services makes adjustments to company-reported financials according to its criteria, and the adjusted measures may diverge from those reported in S&P Capital IQ.

The S&P MidCap 400 is an index of midsize U.S. companies. New entrants range in size from $1 billion to $4.4 billion in market cap, and this range is reviewed periodically by the S&P Index Committee to ensure consistency with market conditions. (See www.standardandpoors.com for details of the S&P MidCap 400 index construction).

Table 6

Table 7