The credit profile of U.S. industrial companies is currently at its weakest level ever. Standard & Poor's Ratings Services expects that, after a short correction, it's likely to drop even further as low-quality new issuers and the declining fortunes of existing rated companies expand the speculative-grade rating categories.
This reflects, in part, the impacts of two long-term trends: (1) investors accepting higher risk and (2) more aggressive corporate financial policies aimed at appeasing shareholders.
U.S. industrial companies (excluding utilities and financial institutions) in the 'B' rating category (which includes 'B-', 'B', and 'B+' ratings) account for nearly half of all Standard & Poor's corporate credit ratings. Now 46% of the total, the category made up just 7% of ratings in 1980. Much of the surge in the 'B' category over the past few years is the result of new middle-market-type companies tapping the bond and loan markets, as well as the dramatic increase in leveraged buyouts.
Credit Quality Within 'B': Marked Deterioration
By 1988, companies in the 'B' category made up about one-third of Standard & Poor's rated universe of U.S. industrials. But after a decade of comparative stability (by 1998, companies in the group had jumped just three percentage points, to 36% of the total), we are seeing another big increase in the 'B' category. In fact, the number of these companies has risen four percentage points from last year alone.
We expect a slight downward adjustment in the next year or so, as lenders may remain relatively risk-averse in the wake of the current credit market turmoil. But signs suggest that the 'B' category will account for more than half of rated U.S. industrials within the next three years.
More meaningful, perhaps, is that even within the 'B' category, credit quality has been deteriorating. For the first time, the flat 'B' rating is now Standard & Poor's largest rating designation, having surpassed the 'B+' designation in 2007. Flat 'B' ratings now account for 46% of the entire 'B' category, compared with 38% for the 'B+' designation.
Look for an Upswing in Defaults
Absent a deep or protracted economic slump, we expect any flight to better credit quality to be little more than a puddle-jump—short and not very high. After an expected correction, we believe the market will resume its long-term trend toward higher credit risk. We also expect a big increase in defaults over the next year or so, thanks to the low quality of debt issuance in recent years.
This recent migration down the ratings ladder in many ways mirrors the move of the 1980s, when the first surge in speculative-grade credits occurred. But that move came at a time when more than two-thirds of rated U.S. industrials were investment-grade. The current weakening of credit is that much more notable because it's happening with companies at a comparatively low starting point.
Naturally, the surge in 'B' credits, which resumed in earnest in 2003, has coincided with a wholesale migration down the credit ladder. Along with a number of "fallen angels" (borrowers that have slipped to speculative-grade from investment-grade), we have seen an exodus of companies from the highest rating levels, as well as hordes of new issuers content with speculative-grade ratings. Over the past four years, Standard & Poor's has assigned more than 1,100 new 'B' category ratings in the U.S. industrials sector.
Investment-Grade Credit Rating: Endangered Species?
Companies have been able to tap lenders that are increasingly hungry for yield. Until recently, that has meant many speculative-grade borrowers have had access to capital at close to what had historically been investment-grade interest rates, as rate spreads sharply narrowed.
The percentage of companies in the investment-grade 'BBB' category (which includes 'BBB-', 'BBB', and 'BBB+' ratings) has ostensibly remained steady, with today's 17% just a percentage point below the 1980 level. Of course, this has been a function of companies rated 'A' and higher dropping down to fill in the spots vacated by those that have sunk below investment-grade. Strikingly, the number of companies rated 'A' and higher has tumbled to just 11%, from 17% in 1998 and from a full 50% in 1980. (Again, much of the migration occurred from 1980-1988, when the number of companies rated 'A' and above fell to 30%.)
The percentage of borrowers that carry a Standard & Poor's rating in the speculative-grade 'BB' category also has remained somewhat steady. This category (which includes 'BB-', 'BB', and 'BB+') now makes up 23% of our ratings—a blip above the 22% of 1980, though notably higher than the 17% seen in 1988.
Clearly, the sharply weakening credit profile of U.S. companies indicates that defaults will almost certainly begin to increase. Simply put, a company rated 'BBB' has a greater shot at survival than a company rated 'B'. Nonetheless, with just over a quarter (28%) of U.S. industrial companies rated 'BBB-' or above, it may come as no surprise if the investment-grade corporate credit rating largely becomes a thing of the past.