Credit ratings agencies saw one of the largest upgrade-to-downgrade ratings ratio shifts ever as economies reopened and credit pressures began to ease following the impact of COVID-19.
Fitch Ratings reported a significant improvement in ratings performance across its non-financial corporate portfolio for the year to the end of July 2021, less than 12 months after recording the highest number of downgrades seen in two decades.
In 2020, the ratings agency downgraded 381 credits—up more than 70% on the number of downgrades recorded in 2019. Only 83 borrowers, meanwhile, received ratings upgrades in 2020, half the number of upgrades made the previous year.
Momentum shift
In 2021, by contrast, ratings actions did a complete about-face. Vaccination programs allowed markets to reopen following lockdowns, improving the outlook for economic growth. The International Monetary Fund forecasts that global GDP will climb by 5.9% in 2021 and 4.9% in 2022.
As a result, Fitch recorded 113 upgrades across its global portfolio in the year to the end of July 2021, outpacing the number of downgrades (101) for the first time since 2017.
A change in financial profile has been the primary driver of more than half (54.9%) of those upgrades. Companies that undertook M&A and disposals during the pandemic to focus on core business and bring in cash also reaped the benefits, accounting for 11.5% of ratings upgrades (equal to upgrades made based on a change in business profile).
The natural resources, energy and building and construction sectors were the main beneficiaries of these ratings rebounds. Recovering commodity prices and increases in residential property renovations (driven by the rise in remote working) boosted earnings and balance sheets in these industries.
While leveraged loan and high yield bond issuance recovered after the initial 2020 lockdowns, suggesting that lenders took a pragmatic view of immediate ratings downgrades, markets continued to favor higher rated credits. This will benefit issuers that have had ratings upgraded.
US institutional leveraged loan issuance for the year to the end of Q3 2021 was heavily skewed toward credits rated B or better, according to Debtwire Par. The same was true of the European loan market.
Higher rated credits in the US also received superior pricing, with institutional first-lien term loan pricing for BB credits coming in at an average of 3.8% so far this year, almost 1% cheaper than the 4.6% average rate for B-rated credits.
A boost for CLOs
Collateralized loan obligation (CLO) managers were also buoyed by the overall improvement in ratings profiles. CLOs remained resilient in 2020, but CLO structures—which are created by pooling together non-investment grade loans—were affected by the large-scale downgrades that swept through the market in the spring of 2020.
When ratings quality is diluted beyond pre-set limitations, especially with respect to the proportion of assets with CCC ratings (usually capped at 7.5%), CLOs can face trading restrictions and divert cash flows away from equity and subordinated debt holders in CLO structures.
The rising number of upgrades coincided with an increase in CLO issuance in 2021. New CLO issuance in the US in the first nine months of 2021 climbed 118% year-on-year to US$127.9 billion, with CLO refinancing up 417% and resets soaring 11-fold.
In Europe, meanwhile, new CLO issuance climbed 75% year-on-year from €14.64 billion in the first three quarters of 2020 to €25.57 billion during the same period this year. CLO resets in the region have risen more than 30-fold to €30.77 billion.
Pragmatism required
While ratings quality is traveling in a broadly positive direction, markets have yet to fully return to pre-pandemic levels. Fitch points out in its analysis that upgrades have been unevenly spread between developed and emerging markets. According to the ratings agency, the ratio of corporate upgrades to downgrades has sat at 1.3x in developed markets, versus a 1-to-1 ratio in emerging markets. This may be an ongoing concern.
Fitch also notes that only one fifth of the upgrades recorded in 2021 served to reverse downgrades made in 2020. Companies affected by lockdowns may still be under pressure, while those that traded well through the pandemic are enjoying an additional uplift from an upgrade.
Many corporate balance sheets are in better shape than they were 12 months ago, but there is still a way to go yet to secure a widespread improvement in credit profiles across the board.