Global Potential Downgrades: Total Climbs To 475--Its Second Consecutive Monthly Increase

The number of global entities that are most at risk of downgrades increased by 10 from our most recent report to 475 as of Sept. 21. The count of potential downgrades was 451 in June--its lowest level in the past six months--and rose in the past two months. The current total is the highest since February, though it's far below its peak of 1,028 in April 2009. Ratings across most sectors appear more stable now than they have historically, though a few sectors, including banks, show higher downgrade risk.

Potential downgrades are entities that have either negative outlooks or ratings on CreditWatch with negative implications across rating categories 'AAA' to 'B-'. This month, we note the following key points:

• Since our last report, we removed 24 entities from the potential downgrades list, and we added 34.
• Standard & Poor's Ratings Services has downgraded 22 entities that were on the potential downgrades list last month. Of these, nine remain on the list with negative outlooks or ratings on CreditWatch with negative implications.
• On Sept. 19, Standard & Poor's Ratings Services lowered its long-term sovereign credit rating on Italy to 'A-' from 'A+'. Following this rating action, four issuers on last month's list of potential downgrades were downgraded, and two entities were added to the list.
• Sectors showing the greatest downgrade risk compared with their average negative bias are banks and sovereigns. Negative bias is the proportion of issuers with a negative outlook or ratings on CreditWatch with negative implications.
• Of the 34 entities added to the list of potential downgrades, 16 are based in the U.S.
• Sovereign issuers account for 5% of the potential downgrades. Seventeen of the 23 sovereign issuers on the list are European and Eastern European/Middle Eastern/African sovereigns.
• By rating, 'B' and 'B+' rated issuers account for the largest proportions of entities with negative outlooks or ratings on CreditWatch negative, with 12% and 11.6%, respectively. Globally, 51% of the 475 issuers at risk of downgrades are rated speculative grade ('BB+' and lower).
• In our view, 18 of the 21 sectors show lower downgrade risk than they have historically. When we measured the gap between the current negative bias and the historical averages, we found that credit conditions in most sectors are less negative than they have been historically.

Standard & Poor's assigns a negative or positive outlook or places a rating on CreditWatch when it expects the rating may change within two years or less. Standard & Poor's CreditWatch status indicates the potential direction of a credit rating change, dependent on identifiable events and short-term trends, and is typically resolved within 90 days. An outlook indicates the potential direction of a credit rating change over the intermediate to long term, generally within six months to two years. A developing outlook indicates that Standard & Poor's may either raise or lower the rating. A negative outlook or ratings on CreditWatch with negative implications are good leading indicators of actual downgrades. CreditWatch status and outlooks are strong predictors of ratings migration. A research study published by Standard & Poor's corroborates this (see "CreditWatch And Rating Outlooks Provide Powerful Warning Signals," published Aug. 7, 2007, on RatingsDirect on the Global Credit Portal). Timely and ongoing surveillance of issuers at risk of downgrades can provide value to investors in their sector credit-allocation process as well as in hedging against potential capital losses arising from a downgrade.

Borrowing costs have risen over the past month as weakening economic conditions have weighed on risky assets. The investment-grade and speculative-grade spreads are both above their one-year moving averages and recently reached highs for 2011. Overall negative bias in September was 15.5%, a slight increase from 15.1% in August and a 3% decrease from a year ago. Negative bias reached its 10-year high of 36.6% in the second quarter of 2009.

The total number of entities with negative outlooks increased to 405 as of Sept. 21 from 396 in the previous report, while the number of entities with ratings on CreditWatch negative increased to 70 from 69. The ratio of negative outlooks to CreditWatch negative listings increased to 5.79 to 1 from 5.74 to 1. An increasing ratio may suggest a longer time horizon for potential rating actions.

Since our last report, we removed 24 entities from the list of potential downgrades. Of these, we removed nine because they now have stable outlooks and another eight because they were downgraded and now have stable outlooks. Another five issuers came off the list because Standard & Poor's Ratings Services downgraded them to lower than 'B-'. In addition, we removed two issuers from the list because they're no longer rated.

Of the 34 entities that we added, 32 are on the list because they now have negative outlooks or ratings on CreditWatch with negative implications. The two other companies, O'Charley's Inc. and Atrium Cos. Inc., were downgraded, and O'Charley's now has a negative outlook, and the rating on Atrium Cos. is on CreditWatch negative.

Standard & Poor's Ratings Services downgraded a total of 22 entities that were on last month's list of potential downgrades. Of these, nine remain on the list for further potential downgrades. Ten of the 22 downgraded entities (45%) are from the U.S., and four are from Italy, including the sovereign (see "Italy Unsolicited Ratings Lowered To 'A/A-1' On Weaker Growth Prospects, Uncertain Policy Environment; Outlook Negative," published Sept. 19, 2011).

Increases in negative bias and the number of potential downgrades generally accompany the onset of a recession. The increase in potential bond downgrades in the 2001 recession was accompanied by an expected decline of those poised for upgrades. At the beginning of the most recent recession, we saw a steeper, more prolonged increase in the number of potential downgrades, which reflected the depth and severity of the downturn. The end of the most recent recession saw an even steeper drop in the negative bias and a rapid increase in potential upgrades, which has subsequently leveled off.

Chart 1

When measured by the gap between the current negative bias and historical averages, sovereigns, oil and gas exploration and production, and banks show more substantial downgrade risk than they have historically. On the other hand, the aerospace and defense, capital goods, retail and restaurants, and automotive sectors show less downgrade risk than they have historically (see table 1).

Table 1

Globally, the sectors most vulnerable to downgrades are banks, utilities, and media and entertainment. When combined, they account for 32% of the total rated companies that have negative outlooks or ratings on CreditWatch with negative implications (see chart 2). The negative biases for the banking, utilities, and media and entertainment sectors are 19%, 17%, and 20%, respectively. We note that the current negative bias exceeds the long-term average for banks and is lower than the long-term average for both media and entertainment and utilities (see chart 3).

Chart 2

Profile By Geography

The companies on the potential downgrades list remain concentrated in the U.S. and Europe (50% and 25% of the total, respectively) (see table 2). This concentration partially reflects the larger rated populations of the U.S. and Europe. The U.S. region (including Bermuda) had 16 entrants to the potential downgrades list since our last report--or 47% of the total new entities. Asia-Pacific had four companies added to the list, or 12% of the total.

Of the 475 potential downgrades, 134 are constituents of Standard & Poor's equity-based indices (see table 3). Of these, 50 belong to the S&P 500 and 24 are affiliated with the S&P Midcap 400. Outside the U.S.:

• 35 belong to the S&P Europe 350,
• 14 are part of the Japan S&P TOPIX 150,
• Four companies are part of the Canada S&P/TSX 60,
• Three Australian entities are constituents of the S&P ASX 50,
• Three issuers belong to the S&P Asia 50, and
• One is on the S&P LatAm 40.

Table 2

Sector Profile Of Potential Downgrades

Chart 3 displays the most recent distribution of negative bias as well as the long-term (1990-2011) average negative bias. The dotted diagonal line across the chart indicates where the current negative bias matches the long-term average negative bias. Sectors that are to the left of the diagonal line indicate higher-than-average risk of a downgrade, whereas sectors to the right of the diagonal line indicate lower-than-average risk. Sectors showing the greatest downgrade risks compared with their average negative bias are sovereigns and banks.

Chart 3

Of the 23 sovereigns on the potential downgrades list, nine (39%) are from Eastern Europe, the Middle East, and Africa, and three entities (13%) are in the Asia-Pacific region. The Republic of Italy was the only sovereign that was downgraded since our previous report. On Sept. 19, 2011, Standard & Poor's Ratings Services lowered its unsolicited long- and short-term sovereign credit ratings on the Republic of Italy to 'A/A-1' from 'A+/A-1+'. The outlook is negative. More subdued external demand, government austerity measures, and upward pressure on funding costs in both the public and private sectors will, in our opinion, likely result in weaker growth for the Italian economy compared with our May 2011 base-case expectations, when we revised the outlook to negative. We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve. Furthermore, what we view as the Italian government's tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy's economic challenges. (See "Italy Unsolicited Ratings Lowered To 'A/A-1' On Weaker Growth Prospects, Uncertain Policy Environment; Outlook Negative," published Sept. 19, 2011.)

Of the 66 issuers in the banking sector on the potential downgrades list, 41 (62%) are based in Europe and 14 (21%) are based in the U.S. region, which includes Bermuda and the Cayman Islands. The dimming growth prospects in the eurozone and the volatile, risk-averse wholesale funding markets are halting the European banking industry's moderate rebound from the 2008-2009 financial crisis. Standard & Poor's Ratings Services believes that a further recovery will hinge on restoring order to the sovereign debt market, shoring up confidence in bank funding markets, and avoiding a double dip into recession in the large European economies (see "Industry Report Card: European Bank Rebound Falters Amid Slowing Economies And Market Turmoil," published Sept. 6, 2011).

Currently, the banking sector also shows the highest vulnerability to downgrades, with 66 issuers, followed by utilities with 50 and media and entertainment with 39 (see chart 4). The sectors with the most issuers removed from the potential downgrades list since last month are media and entertainment; chemicals, packaging and environmental services; and transportation, with three each.

Chart 4

Rating Profile Of Potential Downgrades

By rating, 'B' and 'B+' rated issuers accounted for the largest proportions of entities with negative outlooks or ratings on CreditWatch negative, with 12% and 11.6%, respectively (see chart 5). The 'B' category ('B+', 'B', and 'B-') makes up 35% of the potential downgrades list. Of the total issuers at risk of downgrades, the investment-grade segment ('BBB-' and higher) accounts for 49%, and speculative grade ('BB+' and lower) accounts for 51%. The speculative-grade proportion of the total list remained flat since our last report.

Chart 5

Table 3