The tides are beginning to turn for investors as the ratio of upgrades to downgrades begins to fall. In the first quarter of 2022 the ratio was 6.4x, showing the effects of COVID debt repayment and revenues returning to more normalized levels. However, following the second quarter of this year, the ratio has dropped to 1.2x. This compares to the 15-year average of 0.8x. As you can see, more challenging conditions are beginning to take their toll. Companies are forecasting slower earnings growth moving forward as margins are compressed by rising interest rates and inflationary pressures. At the same time, economic theory suggests rising interest rates will cause an increase in the unemployment rate and a slowdown in consumer spending. In the next six months, Barclays expects the upgrade trend to fully change directions with downgrades outpacing upgrades. Currently S&P, Moody’s, and Fitch have $175 billion of debt on negative watch and $690 billion on negative outlook. Barclays model suggests that $180 billion could be downgraded over the next six months. This would represent about 2.9% of the Investment Grade Corporate index which is much higher than the current 0.6% rolling six-month average, but still comparable to the long-term historical average of 3%. With economic conditions continuing to tighten, it is not unreasonable to anticipate that the volume of downgrades may rise above the long-term average.
Source: J.P, Morgan.
However, not all sectors or ratings buckets are created equal. The BBB rated cohort saw the majority of the downgrades in 2Q22, as shown in exhibit 12, most of which were in the low BBB category. According to J.P. Morgan at the end of the second quarter, there was $940 billion of BBB- rated debt with 12% being on negative outlook at one of the three credit rating agencies. This compares to the end of 2021 when there was $888 billion of BBB- rated debt with 15% on a negative outlook. If you look across the different sectors, based on the proportion of negative outlooks and watches compared to their sector size (Figure 7), you can see that aerospace/defense, natural gas, manufacturing, chemicals, and pharmaceuticals have the most debt on negative outlook or watch. Portfolios with high exposure to these sectors may see meaningful shifts in their risk profiles if the ratings trend changes from positive to negative.
Source: Bloomberg, Barclays Research.
Fortunately, balance sheets are starting from a relatively strong position and companies have adjustments they can make to their share buyback or dividend policies to help defend their ratings and preserve their balance sheets. However, there are no guarantees management teams would be willing to do this as their share prices have suffered this year. As investors evaluate their portfolios, they should be aware of these ratings trends, how it could affect their risk profiles, and which sectors and ratings buckets could be affected the most. Investors that are risk averse or have rating constraints may want to consider adjusting exposure from sectors with higher downgrade risk or the low BBB- rated bucket.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
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Boyd Watterson Asset Management, LLC