Careers Type: About credit

Covenant Review’s report “EU Liability Management: Subordination and Seniority in European High Yield Bonds and Loans” provides an in-depth examination of the ranking and subordination risks prevalent in European high yield bonds and leveraged loans. It highlights the importance of understanding various forms of subordination—payment, lien, and structural—and the significance of intercreditor agreements in managing these risks.

• Payment subordination refers to a debt holder’s repayment hierarchy.
• Lien subordination concerns the relative priority of secured debt claims on collateral.
• Structural subordination happens when non-guarantor subsidiaries incur debt.

You can view the report here.

Research from Fitch Ratings has found an organization’s outlook is a stronger indication of the next rating movement that a previous rating action in negative credit developments. Issuers that were downgraded but with stable outlook were lowered again 9% of the time, whereas those affirmed with negative outlook were subsequently downgraded 24% of the time. Conversely the research found little evidence of momentum in the positive direction.

The research analyzed the momentum in corporate credit ratings, focusing on whether upgrades or downgrades signal future rating actions in the same direction. The research covered around 30,000 actions since 2013 where the previous rating was B- or above.

Below is a summary of the findings.

Negative momentum scenarios:

Rate of downgrade from a stable outlook:

• Downgrade from stable outlook is rare, occurring about 3.5% of the time after an affirmation with stable outlook. These are normally associated with a quicker deterioration than expected and for ratings at the lower end of the rating scale.
• When the previous action was a downgrade but the outlook was revised to stable, the downgrade rate increases to close to 10%.

Rate of downgrade from a negative outlook:

• The rate of downgrade is 30% following a downgrade with negative outlook.
• For issuers affirmed with a negative outlook, the downgrade rate is slightly lower at 24%.

Rate of multi-notch downgrade from a negative outlook:

• Multi-notch downgrades occur 15% of the time following a previous downgrade with negative outlook.
• This is significantly higher than the 5% rate after an affirmation with negative outlook.

Positive momentum scenario:

Upgrade rate from a positive outlook:

• Whether a positive outlook is associated with an upgrade or affirmation seems to have minimal impact on its conversion rate into an upgrade. The authors suggest this reflects the minimal incentives for issuers to halt positive credit developments, or otherwise prevent upgrades.
• New ratings with a positive outlook are less likely to receive an immediate upgrade in the following rating action. Instead, it may take several rating actions before an upgrade happens.

Implications for credit analysts:

• Monitoring indicators: Analysts should pay close attention to outlook changes as they are strong indicators of future rating actions.
  Although a less powerful signal than a negative outlook, the previous action being a downgrade is a relevant indicator of a higher likelihood of a forthcoming downgrade, especially in high yield, compared with issuers which have been affirmed.
• Regional differences: Data for regions do differ from the global average. Emerging market exposure can be a differentiator.
• Ratings actions: Whilst this research only considered two consecutive actions, it may take several ratings actions before a downgrade or upgrade happens.
• Gradual upgrades: Positive outlooks on new ratings should be seen as a long-term positive indicator rather than an immediate precursor to upgrades, requiring sustained positive credit developments.

The full article ‘Corporate Rating Momentum’ is available here. Note that a Fitch Ratings account may be required to access the document.

Fallen angels are companies that once enjoyed investment-grade status but were later downgraded to sub-investment grade ratings. These downgrades often result in increased borrowing costs and a reduced investor base. However, not all fallen angels remain in this state permanently; some manage to regain their former glory and return to investment-grade ratings.

A recent study by Fitch Ratings sheds light on those fallen angels from 2006 and 2019. The report looks at the trends and outcomes these organisations have faced up to 2023. You can view the full report here. Note that a Fitch Ratings account may be required to view the document.

Reasons for downgrades

• Cyclical economic pressures: Recessions and commodity price swings can lead to downgrades as companies struggle with reduced revenues and profitability.
• Regulatory pressure: Changes in regulations can impact companies’ operations and financial stability, leading to downgrades.
• Company-specific actions: M&As, LBOs, and significant changes in financial policies can strain a company’s balance sheet and result in downgrades.
• Acute liquidity issues: Companies facing severe liquidity crunches may also be downgraded to junk status.
• Operational weaknesses: Increased competition, poor strategy execution, general market pressures and exposure to out of favour segments influence downgrades.

Rising stars and regaining IG ratings

The Fitch Ratings study provides a comprehensive analysis of 111 issuers that became fallen angels between 2006 and 2019. Here are some of the notable findings:

• Cyclically driven recoveries: Approximately three-quarters of cyclically driven fallen angels managed to reclaim investment-grade ratings post-recession. Of the issuers downgraded during the GFC in 2008 and 2009 due to recession induced pressure, 80% returned to IG status. Similar patterns appear to be shaping up for the fallen angels of 2020.
• Impact of company-specific actions: Issuers downgraded due to discretionary actions like M&A and LBOs faced greater challenges in recovering. Of the 39 issuers downgraded for reasons partly within their control, only 14 regained their investment- grade ratings, with those engaged in LBOs being the worst affected sub-set.
• Default rates: The study found that 52% of the fallen angels managed to regain their investment-grade ratings, 32% remained below investment grade and 16% ultimately defaulted.
• Variations by cause: Corporates downgraded due to external conditions fared better than those downgraded due to internal decisions. Of the 72 issuers downgraded for reasons outside their control, 61% returned to investment-grade status, compared to only 36% of those downgraded due to internal factors.
• Timing: Prior to 2020, on average it took about 5 years for rising star issuers to return to IG. Currently the outcomes appear positive for downgraded issuers. Of the 35 downgrades of 2020, already 18 have made it back to IG.

A credit rating is an evaluation of the credit risk associated with a borrower or a financial instrument. It reflects a borrower’s ability to repay debt and is based on the analysis of various factors, including financial health, market conditions, and economic outlook depending on the specific rating criteria.

The “Ratings Definitions” report published by Fitch Ratings, offers a deep dive into ratings, with key terms and definitions from across the range of credit ratings:

• Actions and reviews: Ratings are reviewed periodically and as new information arises or circumstances change. Actions include affirmations, upgrades and downgrades.
• Outlooks and watches: Outlooks indicate the direction a rating is likely to move over a one-to two-year period. A watch indicates that there is a heightened probability of a rating change and the likely direction of such a change.
• International credit rating scales: These scales feature the symbols ‘AAA’ (highest credit quality) to ‘D’ (default) and ‘F1’ (highest short-term credit quality) –‘D’ (default). They apply to issuers and obligations across sectors. Credit ratings assigned on these scales assess the capacity to meet financial commitments in local and/or foreign currencies and as such are internationally comparable.
• Corporate finance obligations: Ratings of individual securities or financial obligations of a financial or non-financial corporate issuer address relative vulnerability to default and recovery given default. They range from ‘AAA’ to ‘C’.
• Sovereigns, public finance and global infrastructure obligations: These ratings consider the relative vulnerability to default and range from ‘AAA’ to ‘D’.
• Structured finance: Ratings in this sector assess the relative vulnerability to default of structured finance obligations, typically assigned to individual securities or tranches, and range from ‘AAA’ to ‘D’.
• Financial institution ratings: Government and shareholder support ratings assess the likelihood of extraordinary support to prevent a bank or non-bank financial institution (NBFI) defaulting on its obligations. Viability ratings measure the intrinsic creditworthiness and likelihood of failure of a bank or NBFI. These range from ‘aaa’ to ‘f’.
• Insurer financial strength ratings: These ratings reflect both the ability of an insurer to meet obligations on a timely basis and expected recoveries received by claimants in the event the insurer stops making payments or payments are interrupted, due to either the failure of the insurer or some form of regulatory intervention. They range from ‘AAA’ to ‘C’ and ‘F1’ to ‘C’.
• National credit rating scales: These scales express creditworthiness within a specific country using similar symbols to international ratings but with a country-specific suffix.
• International non-credit rating scales: Ratings such as international money market fund ratings and fund credit quality ratings, focus on different aspects of financial instruments and entities. They are not meant for assessing credit risk but instead offer insights into other characteristics.
• National non-credit rating scales: Similar to international non-credit ratings but specific to a country, these assess relative credit quality within that country.
• Recovery ratings: The recovery rating scale is based on the expected relative recovery characteristics of an obligation upon the curing of a default, emergence from insolvency or following the liquidation or termination of the obligor or its associated collateral. It ranges from ‘RR1’ (91-100% recovery) to ‘RR6’ (0-10% recovery).

The report also highlights important limitations of credit ratings and other opinions. Knowing the scope and limitations of credit ratings allows investors and stakeholders to use them accurately in conjunction with other analyses and data sources, leading to more informed and balanced decision-making.

To view the full report visit the Fitch Ratings’ website.