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U.S. Credit Concerns Rise

Highlights

- Following an escalation of risk of aversion in the fourth quarter of 2018, financing conditions improved in first-quarter 2019, with issuance rebounding and spreads narrowing in the U.S. This followed Fed Chair Jerome Powell's announcement of a pause on rate hikes. While this improved investor sentiment, downgrade risk among corporate issuers inched upward.

- Adding to credit concerns, the number of defaults, the downgrade ratio, and the number of downgrades each rose to their highest levels since 2016, suggesting that downside risks are rising broadly across the credit market.

- On the heels of an active year for M&A, the telecommunications sector takes the lead for the highest negative bias, which is up to 27% after rising by 2 percentage points this year. Meanwhile, the oil and gas sector showed the steepest increase in its negative bias (up 3 percentage points) in the quarter following the drop in crude prices in fourth-quarter 2018.

Apr. 11 2019 — Corporate credit got off to a rough start in January. No new speculative-grade bonds were issued during a 55-day hiatus that began in November. Speculative-grade bond spreads widened to 490 basis points (bps) at the beginning of January, their widest level since November 2016, and crude oil prices began the year near $45 per barrel. Furthermore, the utilities sector was rocked in early January with the downgrade of PG&E Corp. to 'B-' from 'BBB-' after the California Public Utilities Commission opened a proceeding to consider potential penalties against the utility following the devastating Camp Fire, and as PG&E Corp.'s board of directors announced that it was reviewing PG&E's management, finances, governance, and structural options. PG&E subsequently defaulted later in the month.

At the end of January, Federal Reserve Chair Jerome Powell effectively signaled that the Fed was placing rate hikes on pause as it "will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate." Following that announcement, the S&P 500 Index rallied by nearly 5% from the beginning of February through the end of March, speculative-grade credit spreads narrowed to 385 bps by the end of March, and U.S. corporate bond issuance rebounded in February. Also during the first quarter, crude oil prices surged by nearly 33% to $60 per barrel at the end of March.

While the rebound initially showed legs, investor confidence was shaken once again at the end of March, when the yield curve (between the three-month and 10-year U.S. Treasuries) inverted, signaling a heightened risk of recession. As of Feb. 19, S&P Global Ratings' economists see a 20%-25% risk of recession over the next 12 months; this risk has risen from 15%-20% in August 2018.

Despite improved market conditions in the quarter, credit risk measures continue to suggest that concerns are growing for U.S. corporate credit. The downgrade ratio (the share of rating actions that were downgrades) and U.S. corporate defaults each rose to their highest quarterly levels since 2016. Further pointing to a generally upward trend in risk, the distress ratio (defined as the proportion of speculative-grade issues with option-adjusted spreads of more than 1,000 bps relative to U.S. Treasuries) was 7.9% as of Feb. 15, 2019, above its full-year 2018 average of 6%.

Looking forward, downgrade potential for U.S. corporates (including those from the tax havens of Bermuda and the Cayman Islands) rose for both investment- and speculative-grade. This is measured by negative bias (the percentage of ratings with negative outlooks or on CreditWatch with negative implications). The negative bias for investment-grade companies rose to 12% from 11% at the end of 2018. Meanwhile, over the same period, the speculative-grade negative bias rose to 20% from 19%, a 2-percentage-point increase from its level one year ago. The speculative-grade negative bias is at its highest level since December 2017 (see Charts 2 and 3).

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