Corporate Credit as the Cycle Turns

  • By AFP Staff
  • Published: 9/26/2022
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In a recent webinar hosted by AFP, Moody’s, a global integrated risk assessment firm, provided in-depth insight into how corporate credit fundamentals are evolving at a high macro level, the crossover zone, and which areas are most vulnerable to adverse developments in the credit cycle.

The credit landscape

“Let me take you down memory lane and walk you through where we are really coming from in the credit landscape,” said Paloma San Valentin, managing director of Moody’s Investors Service. The last two and a half years in corporate credit land have been a bit of a roller coaster. We went from the sharpest and shortest global credit shock at the outset of the coronavirus pandemic in early 2020, to, within six to nine months, the strongest recovery in years throughout 2021, which was a record year of issuance in the midst of accommodating credit conditions.

We started 2022 expecting some stability and a consolidation of that recovery, but of course, geopolitical risk struck in February when the Russia-Ukraine war unfolded, uncertainty increased and confidence turned very quickly with headlines about persistence, supply chain disruptions, inflationary pressures and rising interest rates and stagflation and the possibility of a global recession — risk, risk, and more risk ahead.

What we're seeing now is that the credit environment is turning, and issuers are facing a much more adverse operating environment. “Just to give you a sense, in our North America portfolio, we've had about one and a half times as many upgrades than downgrades in the first eight months of this year, but the mix has been changing more recently toward fewer upgrades and more downgrades,” said San Valentin.

The default rate went from less than 4% pre-pandemic to 7% by December 2020, then below 2% by April 2022, and it's now slightly over 2%. Moody’s baseline forecast is for it to rise to around 3.8% in the next 12 months. That 3.8% is still slightly below the long-term average of 4%, but not by much. This forecast factors in relatively modest refinancing risk.

Is a recession coming in 2023?

A poll of webinar attendees showed that the majority believe we will enter into a recession in 2023. “The truth is that there are headwinds everywhere,” said San Valentin. “And these headwinds are stalling and could potentially reverse the recovery.” Global economic growth is slowing in the U.S.; for example, GDP is expected to grow by about 1.9% in 2022, and by about 1.3% in 2023. Given the unfolding of events in the European region, the expectation is that they will only see about 0.3% growth in 2023.

“So that's quite significant, and there are substantial risks to the forecast,” she said. For example, a complete shutoff of gas flows from Russia to Europe. “We're not calling a global recession today. It's not our base case, but we're seeing a meaningful deceleration in the global economy,” said San Valentin.

The world is facing a long list of risks and challenges, including energy and food security. It’s also incredibly complex with a lot of global interconnectivity. In many ways, the world is smaller today than it’s ever been. This is where we are. Now, where are we going?

Conditions of greatest concern

Global credit conditions have turned more negative and are expected to tighten further over the coming months. For several reasons, we have rising borrowing costs. We have the prospect of what may be a protracted military conflict between Russia and Ukraine. We have materially slower growth of the world economy. We have elevated prices for energy and commodities. We have longer-lasting supply chain disruptions, and we have increased financial market volatility. Plus, the slowdown in China could prove to be more severe than anticipated and potentially trigger a wider spread of deterioration in global growth and credit conditions.

The combination of lower growth and higher inflation along with rapidly rising interest rates make for weakening credit conditions alongside all of the other risks in the background. Inflation should start easing later this year and well into 2023. In the U.S., software demands, ongoing improvements on the supply side and more stable energy prices should help, but the inflation rates could persist for several more months.

The three key macro things to watch over the next 18 months are: 1) the evolution of the Russia-Ukraine war, 2) the speed and extent of global monetary tightening, and 3) the trajectory of China's economy.

The most vulnerable companies will be those with weaker credit fundamentals, particularly in sectors that have not yet fully recovered from the pandemic or are otherwise on the receiving end of most of the new risks. Why is that? These companies are now seeing lower growth prospects, higher production costs and rising interest rates biting on their cash flow. They will need to maintain access to markets for their funding or refinancing needs, and if market liquidity retreats or confidence evaporates further, credit risks will emerge.

The crossover zone

The crossover zone refers to the ratings closest to the line between speculative grade and investment grade, and includes non-financial companies rated either Ba3 or Ba1 (Moody’s ratings). Potential “fallen angels” are companies rated Ba3 and are either on review for downgrade or have a negative outlook, while potential “rising stars” are rated Ba1 and are either on review for upgrade or have a positive outlook. 

For this data set, non-financial companies include utilities, REITs and infrastructure issuers, and all debt totals include Moody’s standard adjustments. The number of companies in the crossover zone has trended downward over the past two years as potential fallen angels have materially declined as credit profiles strengthened, along with the post-pandemic recovery, despite its uneven trajectory and building downside risks.

The 34 potential fallen angels represent only about 3% of investment-grade and 4% of B-rated entities. The current low level of potential fallen angels demonstrates the strength of the post-pandemic recovery, and the resilience of investment-grade-rated companies in the face of increasing risks.

Although the median U.S. Ba-rated company now has moderately higher leverage than it did in 2007, it is substantially larger, more profitable and less burdened by interest expense. This indicates that, overall, there has not been any material deterioration in relative credit worthiness. In other words, Moody’s standards for rating Ba companies have not changed. “In general, we expect the resiliency of investment-grade ratings to continue during this period of economic weakness,” said Michael Corelli, senior vice president of Moody's Investors Service.  

Investment-grade companies typically have good flexibility and multiple levers they can pull to address liquidity and refinancing needs including reducing capital spending, share buybacks and dividends, and increasing asset sales. Therefore, while the number of potential and actual fallen angels could increase modestly in a recession, Moody’s anticipates that the absolute numbers would remain at relatively low levels.

Where key vulnerabilities lie

Moody's U.S. credit compass is a newly constructed proprietary indicator that provides a visual representation of recent and forecasted credit trends, telling us whether they are weakening, strengthening or unchanged from one quarter to the next. Currently, the compass projects that deteriorating sentiment and tightening liquidity will result in weakened credit conditions.

That said, “Overall, the compass indicates an upswing in the U.S. credit cycle,” said DeForest. The credit compass scores and aggregates data across the spectrum of U.S. non-financial and financial companies, municipalities and structured finance transactions rated by Moody’s, including both investment-grade and speculative-grade debt issuers. “This is not a corporate measure,” said DeForest, “but a U.S. measure across rating groups.”

Moody’s research estimates that if benchmark interest rates in the U.S. were to increase by 300 basis points from year-end 2021 levels — a pace we might be on — interest expense could become untenable for about half of the Ba3-rated companies in North America. Additionally, the signal has shifted over the course of 2022 to a negative bias, well below its long-term average, providing another strong indication of tightening financial conditions.

The 2022 year-to-date defaults globally reached 48, up from 33 in the same period last year. The U.S. default rate is projected to rise to 4.2% while staying below its long-term average. Default expectations are somewhat worse in the U.S. than in the rest of the world, due to the prevalence of private-equity-backed companies, which often exhibit very high levels of financial leverage and aggressive financial strategies and are rated at the bottom of Moody’s B-scale.

It is expected that the list of high, long-term default risk issuers, which has remained essentially flat at about 11% (4% below the long-term average) will grow in the coming months with financial sponsored transactions leading the way. Finally, the expectation is for an ongoing weakening of covenants in new debt — financings covenants are the borrower requirements and limitations inside debt agreements that protect creditor interests, things like limitations on dividends, the occurrence of incremental debt and investments and requirements around the maintenance of certain financial measures such as maximum debt leverage and minimum interest coverage.

The bottom line on risks and expectations

A lot is at risk and expectations have rapidly changed globally. Within the Moody’s-rated universe, “We are more concerned about those companies with weaker business models, weaker cash flow generation, and weaker financial strength as they will be more vulnerable to the headwinds, particularly if they are in sectors that are still struggling from the pandemic, or are in those sectors likely to be hit harder by the new evolving themes,” said San Valentin.

Key to the preservation of credit quality is the focus on retaining and enhancing financial flexibility. In other words, cash flow generation and liquidity.

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