Credit Ratings Migration Favours Europe over US

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One of the elements we look at on our dashboard that guides us on the state of the economic cycle is credit rating migration. We look at spread movements too, but rating change gives us another line into the risk that rated entities are taking or are confronted with. While we recognise that rating change is a backward looking indicator, viewed in conjunction with other measures, it is possible to draw some important conclusions.

Ultimately, spread changes tend to lead the way (but they can be notoriously volatile in both directions) followed by rating migration, and then ultimately if conditions are bad enough we have recession and the beginning of a new default cycle.

Starting in North America, and using Moodys data as the source, 2019 so far has seen 97 downgrades and 75 upgrades, giving an upgrade to downgrade ratio of 0.77. Within this figure there were 8 “fallen angels” meaning a credit that moves from investment grade to high yield, a topic that has been well discussed this year as fears mount that the volume of BBB’s that could default and overwhelm high yield markets. Anyway, 0.77 is not an alarming figure, but it is becoming a trend, with Q4 last year also showing more downgrades with a ratio of 0.79. In 2016 the ratio hit an intra-cycle low of 0.52 as the US skirted with a recession from the metals, mining and commodity crisis, but ultimately this mini dip probably caused companies to sober up and avoid taking on extra leverage. However, this wake up call has now worn off and leverage is increasing in the US, which is not a good sign especially as interest rates have been hiked 9 times. Bulls will say that interest coverage still looks strong, but as interest expense increases through rate hikes, and gearing goes up, companies are more vulnerable to when the top line stalls and goes into reverse during recession, and this is what creates the default cycle. Of all the main geographies, we think the US is most vulnerable to a default cycle, which makes us more cautious on US corporate credit.

Moving on to Europe, so far there have been 59 upgrades and just 24 downgrades, an extremely healthy ratio of 2.46. For the BBB bears, we note that there has been only 1 fallen angel and against that 3 rising stars; so this worry is not yet one for today. 2018 showed a ratio of 1.84 upgrades to downgrades, which was the highest since before the global financial crisis, although we did note a slightly erratic Q4 where the number dropped to 0.55. This shows again that these figures must be reviewed consistently over time and holistically with other measures. So with interest rates so low, why are we not seeing more leveraging in Europe? The truth is that we are seeing some, just nowhere near as much, and Europe’s banks as a whole have not been in a position to facilitate this gearing. However, we must also note that the business environment has not been as favourable in Europe thereby keeping a lid on corporate exuberance. So while many would correctly argue that Europe is teetering with recession (again), we are a lot less concerned about a default cycle, as we have had no rate hikes to add pain to interest coverage or as much additional leverage being taken. Consequently a recession, although bad for companies, would not lead to a large spike in defaults in our view.

Lastly we should look at the UK, where Brexit headlines have dominated for the last 2.5 years, and look set to continue. The sample of rated companies is naturally a lot smaller, which can lead to more volatility in this exercise. Year to date there have been just 6 downgrades and 20 upgrades, giving a ratio of 3.33, the highest since before the global financial crisis. Among the downgrades, none were fallen angels. Looking at recent history, there were plenty of downgrades in 2017, when the ratio went as low as 0.43, most likely as the UK economy stalled and rating agencies took the referendum result as the trigger to downgrade; but since then the picture has been solid. Today’s ratio does look rather high but this could well be because agencies are taking their time to see how Britain negotiates its exit from the EU. Without attempting to be too positive on the UK, it is clear that the business environment has not been favourable for companies to engage in large scale capex plans or excessive leveraging, which from a fixed income viewpoint is good. Secondly with one rate cut and an equivalent hike, the cost of financing remains very low. Combining all this we have a similar result to Europe, which is that a recession in the UK would most likely not lead to a large spike in defaults.

Apart from being a useful exercise, we believe the above provides strong support for favouring credit risk from both Europe and the UK (selectively) over that from the US at this stage of the cycle.

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