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Uncertainties Impact Credit Risk in the European Union and the UK

Companies within the European Union (EU) have experienced significant turbulence over the past year with the COVID-19 pandemic and are braced for more with the finalisation of the UK’s exit from the EU. Figure 1 shows historical speculative default rates provided in CreditPro®, an S&P Global Market Intelligence offering that provides rating transition, default and recovery rate analytics. For the EU including the UK (EU+UK), we saw spikes for speculative grade companies in 2002 with the tech bubble and in 2009 following the global financial crisis.

Figure 1: EU+UK and Global Trailing-12-Month Speculative Grade Default Rate


Source: S&P Global Market Intelligence, CreditPro as of November 15, 2020. For Illustrative purposes only.

In order to gain a mid- to long-term view of how the credit risk of different industries in the EU and UK are responding to market conditions, we used the latest available financials. We then calculated the median credit risk using S&P Global Market Intelligence’s Fundamental Probability of Default model (PDFN), which looks at company financials and business risk factors to measure the likelihood of default for public and private companies.

In Figure 2, we analyse the median PDs for the EU+UK region by industry, focusing on a range of industries/sectors that display the highest median PDs, highest change in PDs and lowest PDs.  As can be seen, airlines (denoted by the orange line) exhibited both the highest PD and the biggest increase in PD between Q4 2019 and Q2 2020, rising from a median PD of 3.88% to 5.74%, which is equivalent to an implied credit score of ‘b-’. The sharpest increase happened in March 2020 as the European Council started implementing travel restrictions, including banning incoming travel from countries outside the EU. As a result, many airlines have needed government support to stabilise their operations and made extensive cuts in staffing, warning of potential defaults and, in some cases, possible bankruptcy.[1]

Figure 2: PD Fundamental Evolution in EU+UK by Sector

Source: S&P Global Market Intelligence, as of November 15, 2020. For Illustrative purposes only.

The media and entertainment sector experienced a median PD spike from 3.33% to 4.2% (between Q4 2019 and Q2 2020), with this increase showing entirely in the Q2 2020 financials. Many theatres and cinemas were closed or restricted due to social distancing rules, much of the new cinema content was released straight onto home entertainment formats, plus live sporting events experienced a shutdown of all games causing a fall in attendance revenues. Advertising revenue has also been severely impacted, with a lack of spending on traditional advertising formats, partially due to more people working from home and the aforementioned sporting restrictions.

The pharmaceuticals, biotechnology and life sciences sector (represented by the black line) showed a rise in the median PD from 2.02% to 2.59% (from Q4 2019 to Q2 2020), largely driven by the biotechnology sub-sector, with pharmaceuticals and life sciences only experiencing a marginal increase[2] and decrease in credit risk, respectively. Biotechnology experienced most of the risk increase within companies not working on COVID-19-related projects, due to the stopping or slowing down of clinical trials. There was also a decrease in the regulatory interaction that is needed to progress these trials because COVID-19 took priority.

Hotels, restaurants and leisure experienced a 15% increase in their Q2 PD rising from 2.48% to 2.87% (from Q4 2019 to Q2 2020), as restricted operations and forced closures were imposed on companies within these industries by many of the governments across the EU (such as cruise lines receiving no sail orders). This was widespread in the months up to June. Despite the serious impact to these industries, it has been somewhat mitigated by other factors. Cruise lines, for example, are said to have benefitted from extremely loyal clientele who have made pre-bookings for 2021 and, in the case of refunds for cancellations, some customers have accepted an upgraded or discounted service. 

Utilities consistently retained the lowest PD levels throughout this period, the credit strength of these companies being buoyed by the essential nature of utility services. Companies in many parts of this sector retained relatively strong financial performance, however. The small increase in PD seen in Q2 2020 partially came as a result of the decrease in commercial and industrial demand for power, gas and water. This impact has likely been lessened by fixed charges and by the increase in residential demand, as more people began to work from home. Some customers struggling to pay their bills and seasonal factors will likely continue to have an adverse effect on the credit risk.

Worth mentioning are those sectors that did well in our analysis, such as energy that had the biggest fall in PD over the second quarter, from 4.05% to 3.26%, related to the recovery of oil prices from the historic low we witnessed in April 2020. Healthcare equipment and services also saw a fall in credit risk, given how critical these products and services are, especially now during the pandemic. Retail remained surprisingly stable in Q2 2020 (despite exhibiting the second highest PDs) with some businesses in this sector capitalising on solid online demand, supportive government policies and an ease in lockdown measures.

Transition of credit risk in EU countries

Grouping the fundamental PDs of public and private companies across the EU+UK by credit score (e.g., ‘bbb+’, ‘bbb’, ‘bbb-’, etc.), we are able to observe the transition of credit scores from Q1 2020 to Q2 2020. Figure 3 shows that the percentage of companies with ‘aa-’ to ‘bb-’scores decreased in Q2 2020, while the percentage of companies with scores that would be considered speculative grade at ‘b-’ or below increased. The largest shift was at the score level ‘bbb+’ in Q1 2020. This indicates that, for the most part, there was a weakening in the fundamentals across these companies and a deterioration in credit quality, despite government enacted support measures, such as the payment moratoria and furlough schemes that helped to improve the financial picture amongst many industries. Overall within this sample of companies, there was an increase in the percentage of companies with lower credit scores by Q2 2020.  This negative shift was linked to the market pressures arising from COVID-19.

Figure 3: Transition of Credit Score Q1 2020 – Q2020

Source: S&P Global Market Intelligence, as of November 15, 2020. For Illustrative purposes only.

In summary, PD fundamentals reveal a mid- to long-term credit risk pattern based upon financial statement data. When we look at how the credit risk of industries in the EU+UK have been impacted over the first and second quarter of 2020, we see airlines, hotels and restaurants, media and entertainment and biotechnology (although this latter industry was mixed) being among the most affected. Other industries, such as energy, were actually stable or saw some marginal improvement. This indicates that some of these companies are more resilient, have sufficiently strong credit quality or have less exposure to social distancing rules. Overall, a higher percentage of speculative grade companies have transitioned to lower credit scores and the number of investment grade companies have significantly decreased.

[1] List of bankrupt airlines in the EU includes Air Italy, Flybe, German Airways and Jet Time.

[2] Small increase in pharmaceutical’s median PDs could be due to a combination of factors, including people with newly-experienced illnesses refraining from visiting their doctors and accessing new prescriptions, and the supply chain disruptions that occurred earlier in the year. 

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