Bond Downgrade Potential In Emerging And Developed Markets, Including The U.S. And Europe: The Total Potential Downgrades Reaches The Highest Level Since 2010

The number of potential downgrades is at its highest level since the count reached 519 in November 2010. Potential downgrades are entities that have either negative outlooks or ratings on CreditWatch with negative implications across rating categories 'AAA' to 'B-'.

As of March 30, 498 entities were most at risk of downgrades--up from 483 as of Feb. 29. Banks comprise 14% of the potential downgrades, followed by utilities (9%) and media and entertainment (8%).

This month, we note the following key points:

• Since our last report, we removed 32 entities from the potential downgrades list and added 47. Of the issuers we added, 28 are based in the U.S. and five are based in Europe.
• Of the 72 banks on the potential downgrades list, 44 (61%) are based in Europe and 14 (19%) are based in the U.S. region, which includes Bermuda and the Cayman Islands.
• Standard & Poor's Ratings Services downgraded 31 entities that were on the potential downgrades list last month.
• The bank and sovereign sectors show the greatest downgrade risk, compared with their average negative biases. Negative bias is the proportion of issuers with negative outlooks or ratings on CreditWatch negative.
• Of the 498 potential downgrades, 142 are constituents of Standard & Poor's equity-based indices.
• By rating, 'B' and 'B+' rated issuers account for the largest proportions of entities with negative rating outlooks or ratings on CreditWatch negative, at 14% and 10%, respectively. Globally, Standard & Poor's rates 52% of the 498 issuers at risk of downgrades speculative grade ('BB+' and lower).
• In our view, 19 of the 21 sectors on the potential downgrades list 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 not as negative as they have been historically.

Standard & Poor's assigns a negative or positive outlook or places a rating on CreditWatch when it believes 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 negative are good leading indicators of actual downgrades. CreditWatch status and outlooks are strong predictors of rating 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 be valuable to investors in their sector credit-allocation process, as well as in hedging against potential capital losses arising from a downgrade.

The investment- and speculative-grade spreads--which reached their 12-month highs at the beginning of October--are both lower than their one-year moving averages as of March 30. In March, overall negative bias was 17.1%--down slightly from 16.8% in February and about 2.3% lower than a year ago. Negative bias reached its 10-year high of 36.6% in the second quarter of 2009.

Changes In The Potential Bond Downgrades

The total number of entities with negative outlooks increased to 434 as of March 30 from 425 in the previous report, while the number of entities with ratings on CreditWatch negative increased to 64 from 58. The ratio of negative outlooks to CreditWatch negative listings decreased to 6.8 to 1 from 7.3 to 1. A decreasing ratio may suggest a shorter time horizon for potential rating actions.

Since our last report, we removed 32 entities from the list of potential downgrades. Of these, we removed 19 because Standard & Poor's revised the outlooks to stable, eight because they were downgraded and the outlooks revised to stable, and three because Standard & Poor's downgraded them to below 'B-'. We also removed one entity, Datatel Inc., from the list because it is no longer rated and removed another entity, Hokkoku Bank Ltd., because it no longer has outstanding debt.

Of the 47 entities we added to the list, we added 45 because their rating outlooks or CreditWatch statuses were revised to negative. In addition, one company, RadioShack Corp., was downgraded and the outlook revised to negative. One company, Great Atlantic & Pacific Tea Co. Inc. (The), is newly rated.

Standard & Poor's downgraded 31 of the entities that were on last month's list of potential downgrades. Of these, eight (26%) are from Europe, and 14 (45%) are from the U.S.

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 a decline in the number of entities 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 was marked with an even steeper drop in the negative bias and a rapid increase in potential upgrades, which subsequently leveled off.

Chart 1

When we measure the gap between the current negative bias and the historical averages, the sovereign and bank sectors show more substantial downgrade risk than they have historically. Meanwhile, the high technology, aerospace and defense, and automotives sectors show significantly less downgrade risk than they have historically (see table 1).

Table 1

Globally, the banks, utilities, and media and entertainment sectors are the most vulnerable to downgrades (based on the number of potential bond downgrades). When combined, these sectors account for 32% of the total rated companies with negative outlooks or ratings on CreditWatch negative (see chart 2). The negative biases for the banking, utilities, and media and entertainment sectors are 25%, 19%, and 20%, respectively. The banks' and sovereigns' current negative bias exceeds the sector's long-term average (see table 1).

Chart 2

Profile By Geography

The companies on the potential downgrades list remain concentrated in the U.S. and Europe (44% and 30% of the total, respectively), which partly reflects the fact that many of the entities Standard & Poor's rates are in these regions (see table 2). Of the 47 issuers added to potential downgrades list since our last report, 28 (or 60%) are from the U.S. region (which includes Bermuda and Cayman Islands). Europe and Asia-Pacific follow, with five (11%) issuers each.

Of the 498 potential downgrades, 142 are constituents of Standard & Poor's equity-based indices (see table 3). Of these, 41 belong to the S&P 500 Index and 24 are affiliated with the S&P MidCap 400 Index. Outside the U.S.:

• Forty-four belong to the S&P Europe 350;
• Twenty-one are part of the Japan S&P TOPIX 150;
• Five Australian entities are constituents of the S&P ASX 50;
• Four companies are part of the Canada S&P/TSX 60; and
• Three issuers belong to the S&P Asia 50.

Table 2

Sector Profile Of Potential Downgrades

In our analysis, we determine the most recent distribution of negative bias, as well as the long-term (1990-2012) average (see chart 3). 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 have higher-than-average risk of a downgrade, whereas sectors to the right of the diagonal line have lower-than-average risk. The sovereign and bank sectors show the greatest downgrade risk compared with their average negative bias.

Chart 3

Of the 72 potential downgrades in the banking sector, 44 (61%) are based in Europe and 14 (19%) are based in the U.S. The years leading up to and during the 2008-2009 financial crisis witnessed a torrent of mergers and acquisitions among financial institutions across the U.S. and Europe. As a result, a significant amount of goodwill and other nonservicing-related intangibles currently sit on bank balance sheets. In fact, for the top 100 banks we rate, more than $814 billion of these asset types have accumulated on the banks' balance sheet--48% in European banks, 38% in U.S. banks, and 14% elsewhere (see, "Why U.S. And European Banks' Goodwill Assets Are Under Pressure," published March 28, 2012).

Of the 32 sovereigns on the potential downgrades list, 14 (44%) are in Europe (excluding Eastern Europe), three each (9%) are in Latin America and the Asia-Pacific region, 11 (34%) are in Eastern Europe, the Middle East, or Africa, and one (3%) is the U.S. We believe uncertainty and change will characterize the global economy in 2012. Much of the recent analysis of the global economy has focused on the possible negative impact recessionary trends and financial stress in developed countries could have on the emerging markets. However, there is also a risk of possible abrupt changes in the rules of the international economic system, which could alter the global context for analyzing individual countries. Such potential changes could arise from a growing divergence in economic policy priorities between the emerging markets and the developed countries that might persist for many years (see, "The Changing Global Economic Landscape And Its Impact On Latin America," published March 14, 2012).

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, at 14% and 10%, respectively (see chart 5). The 'B' category ('B+', 'B', and 'B-') represent 34% of the potential downgrades list. Of the total issuers at risk of downgrades, the investment-grade segment ('BBB-' and higher) accounts for 48%, while the speculative-grade segment ('BB+' and lower) accounts for 52%.

Chart 5

Table 3

Related Criteria And Research

• Why U.S. And European Banks' Goodwill Assets Are Under Pressure, March 28, 2012
• The Changing Global Economic Landscape And Its Impact On Latin America, March 14, 2012
• CreditWatch And Rating Outlooks Provide Powerful Warning Signals, Aug. 7, 2007