Careers Type: About credit

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.

The structural design of an organization influences its credit rating and overall creditworthiness. Financial institutions (FIs) may choose to adopt complex organizational structures and intragroup dynamics for a range of reasons such as tax efficiencies and cost optimization. However, whilst these strategies can yield financial benefits, they also introduce several risks and challenges that impact credit assessments.

Utilizing Brazil as a case study, in the report ‘What Investors Want to Know: Can Complex Organization Structures Have a Negative Effect on Ratings of Brazilian Financial Institutions?’, Fitch Ratings highlights some of the key organizational factors influencing an institution’s credit rating.

To read the full report, follow this link. Please note that a Fitch Ratings account may be necessary to access the report.

Organizational factors influencing credit ratings:

Tax optimization

• Where companies may build complex structures primarily for tax efficiency, these arrangements can constrain financial analysis due to their unconventional nature and potential opaqueness. The intricacy and ownership dynamics often hinder the clear assessment of risks.
• Tax-efficient structures may attract increased regulatory scrutiny, leading to potential disputes and penalties from tax authorities, which can negatively affect credit ratings.

Financial transparency

• The lack of transparency and limited visibility into operations and financial transactions raises concerns about their true nature and implications, making it difficult for credit rating agencies to accurately evaluate the organization’s financial health.
• Fitch Ratings refrains from rating entities that exist solely for tax and accounting purposes without fundamental economic operations, underscoring the importance of transparent financial practices.

Regulatory environment

• A regulatory framework is positive in that it requires issuers to comply with a minimum set of requirements on leverage, credit risk provisioning and corporate governance.
• For fintechs and other entities operating outside regulatory frameworks, remaining unregulated is not viewed negatively in terms of credit. However, Fitch Ratings considers that regulation provides a level of oversight and standardization that enhances creditworthiness.
• Offshore vehicles and entities based in favorable tax jurisdictions reduce financial statement transparency, complicating the evaluation of credit profiles and associated risks.

Operational performance

• Some diversified conglomerates designate a single company within the group as the cost center, often resulting in weak financial performance for that entity. This can detract from the overall creditworthiness of the group.
• Practices such as asset sales and intragroup debts can serve as indirect methods of support to bolster revenues or reduce leverage. While these strategies can improve short-term financial metrics, they may obscure the true financial condition and sustainability of the organization.

The creditworthiness evaluation landscape is evolving rapidly, driven by the growth in usage of alternative data in financial analysis. Alternative data refers to information not traditionally used by financial institutions for creditworthiness evaluation. This can include anything from social media activity, online customer reviews or a company’s environmental, social, and governance (ESG) practices. These novel inputs offer fresh perspectives on an organization’s financial health and potential risks, complementing traditional data sources.

Alternative data, alongside open banking concepts and increased capacity of big data analytics can provide a more nuanced understanding of, and smarter methods to assess an organization’s creditworthiness. Examples could include robust ESG practices which may indicate a lower risk profile, while negative online reviews could signal potential future revenue declines. As such, alternative data can supplement traditional metrics like debt ratios and cash flow analysis, providing a more comprehensive view of credit risk.

The use of alternative data in financial analysis can unlock credit opportunities for organizations that might be overlooked by traditional credit scoring models, particularly small businesses or startups. It can also enhance predictive accuracy, thereby reducing default risk.

However, the use of alternative data isn’t without challenges. Concerns around data privacy, the quality and reliability of non-traditional data sources, and the potential for discriminatory practices arise. As the use of alternative data expands, it is expected that guidelines on what constitutes acceptable data for credit evaluation will follow to ensure ethical and fair practices.

When using alternative data to assess a company’s creditworthiness, an analyst should consider the following factors:

• Data relevance: Ensure that the alternative data is relevant to the specific analysis. For example, social media activity might be more relevant for a consumer-oriented company than a B2B business.
• Data quality and reliability: The data should be accurate, consistent, and reliable. Since alternative data can come from various sources, checking its credibility is crucial.
• Privacy and compliance: Analysts must ensure they’re in compliance with all relevant data privacy laws and regulations when collecting and using alternative data.
• Data interpretation: Understanding how to interpret alternative data correctly is essential. Misinterpretation can lead to incorrect conclusions about a company’s creditworthiness.
• Integration with traditional data: Analysts should consider how alternative data complements traditional financial data. The goal is to use alternative data to enhance the insights gained from traditional data, not replace it.
• Bias and fairness: It’s important to ensure that the use of alternative data doesn’t result in unfair or biased assessments. For instance, using social media activity might disadvantage companies that do not actively use these platforms.
• Data timeliness: The timeliness of alternative data is also important as outdated information may not accurately reflect the current financial health of a company.
• Scalability: Analysts need to consider whether the alternative data source can be scaled across multiple companies or industries for comparative analysis.