The onset of the pandemic posed challenges to stable and struggling companies alike. Many were forced to cut costs in order to boost liquidity, while the pandemic halted business and consumer spending. A strong rebound in profitability has since occurred across various corporate sectors, as lockdown mandates were lifted and vaccine rollouts prompted increased consumer activity. With companies reporting increased sales and regaining pre-pandemic stability, the rating agencies have upgraded billions of dollars of U.S. corporate debt.
This week’s chart highlights historical credit rating trends for broad investment-grade and high-yield corporate debt. The chart includes the ratio of rating upgrades to downgrades, as reported by Moody’s. Any value greater than 1 indicates that a quarter featured more rating upgrades than downgrades, while a ratio less than 1 conveys the opposite. During 2020, total rating changes nearly doubled relative to 2019, with downgrades heavily outweighing upgrades. This trend reversed starting in the fourth quarter of 2020, and the upgrade/downgrade ratio reached 6.50 by the end of the second quarter of 2021. The dramatic improvement in credit quality can also be seen in corporate yield spreads. On March 31, 2020, the weighted-average option adjusted spread (OAS) for the Bloomberg Barclays U.S. Corporate Bond Index reached its widest level since the 2008 financial crisis. The OAS for the index tightened more than 200 basis points by the end of the second quarter of 2021. During that same time, the upgrade/downgrade ratio rose from 0.13 to 6.50.
Store reopenings and vaccine rollouts have supported strong economic growth while the Federal Reserve has provided monetary stimulus, ultimately driving down borrowing costs for companies. However, the surge in the Delta variant has posed problems for both companies and policymakers. Uncertainty surrounding possible mandate renewals and the Delta variant’s economic impact weighs on companies recovering from previous shutdowns. I would expect rating upgrades to slow through the second half of 2021 and the overall upgrade/downgrade ratio to normalize around 1.00. I don’t anticipate a scenario of widespread downgrades, witnessed at the beginning of the pandemic, to repeat since many companies cut costs during the pandemic to preserve liquidity.
Key Takeaway
With credit quality greatly improved since the height of the pandemic, corporate yield spreads and rating upgrades have moved in opposite directions. The rating agencies have rewarded those companies with ample liquidity and modest leverage with upgrades. I would be wary of companies looking to boost shareholder returns too quickly or taking on unmanageable levels of cheap debt. I expect the rating agencies to be careful in assigning upgrades and downgrades, with the pace of overall changes decreasing relative to the last 12 months.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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