(Editor's Note: As the current credit cycle approaches record length, our "When The Cycle Turns" series looks at the impact that a downturn involving deteriorating economic and credit fundamentals--with rising defaults and scarce liquidity--may have on ratings and market conditions. This article is part of the series.)
The current credit cycle is in its later stages, and a sustained reversal of the ultra-low borrowing costs that corporations have enjoyed for years might already be starting. We expect rates to continue to slowly rise over the next 12 months, However, we don't foresee any drastic change in access to capital in the near term, especially for the $3 trillion 'BBB' rated corporate bond market. Still, markets have been showing both signs of increasing uncertainty and persistent optimism. Investor concerns over global geopolitical events--notably the increasing acrimony around trade--have led to increased market volatility this year and could pose headwinds in the near term if they continue to escalate.
The 'BBB' bond category is now larger than the entire speculative-grade segment (rated 'BB+' and lower). This makes investors broadly exposed to 'BBB' debt through diversified mutual funds, ETFs, insurance, and pensions. Low interest rates and attractive financing conditions have contributed to part of this rise, as have the downgrades of a few large banks and telecommunications companies into the 'BBB' category. While defaults among 'BBB' rated issuers are relatively rare, a small share of 'BBB' category issuers are downgraded to speculative-grade each year, and these risks grow over a longer time horizon. This results in more challenging funding conditions for the issuer, and its bondholders can see the value of their bonds fall. Sustained economic growth has been supporting credit conditions in the U.S., and 'BBB' issuers have experienced above-average rating stability in recent years. S&P Global Ratings' economists forecast growth continuing at near 3.0% through 2018 , alongside low odds of a recession through the first half of 2019 (10%-15%). This current economic trajectory should also continue to support these favorable trends.
- As borrowing costs fell in recent years, many issuers' appetite for risk increased, and they took on more debt. As a result, 'BBB' corporate debt accounts for a growing share of the U.S. corporate debt market, and 'BBB' bonds now surpasses $3 trillion, outpacing the entire speculative-grade segment.
- The weighted-average annual downgrade rate for 'BBB' issuers to the speculative-grade categories is 4.5%, and during the most recent credit cycles, the annual downgrade rate for 'BBB' issuers peaked at 7.6% in 2009 and 9.2% in 2002.
- There are currently 28 companies as of July 9, 2018, in the U.S. that are considered to be potential fallen angels (which are issuers rated 'BBB-' with negative outlooks or ratings on CreditWatch with negative implications), and these issuers have less than $90 billion in associated debt. Both the number of potential fallen angels and their related debt remains well below the highs reached during stress periods in 2002 and 2009.
- We believe that the credit cycle is in its later stages but expect the relatively favorable lending environment to continue into the first half of 2019. This--combined with our current ratings mix, a manageable maturity profile, and the outlook/CreditWatch distribution--makes us conclude that although the current population of 'BBB' firms in the U.S. is large, it should remain stable from a credit perspective in the near- to medium-term horizon.
By dollar amount of rated debt (including financial and nonfinancial companies), 'BBB' is the largest among rating categories. The majority of investment-grade corporate bonds in the U.S are in the 'BBB' category, and the amount of bond debt rated in the 'BBB' category exceeds the entirety of speculative-grade debt, including both bonds and leveraged loans. A relatively small share of these 'BBB' corporate bonds are in the lowest investment-grade rating: 'BBB-' (see Chart 1).
While $3 trillion of U.S. corporate bonds in the 'BBB' category are currently outstanding, the majority of these do not mature until after 2023. The maturity wall for 'BBB' corporate bonds appears to be manageable, especially given the high levels of investor demand that we've seen for this type of credit in recent years. In the 'BBB' category, $310.7 billion of corporate bond debt is set to mature from July 1, 2018, through the end of 2019, and companies have reduced this amount by 14% since the beginning of 2018. Through 2023, $1.33 trillion in corporate bond debt rated in the 'BBB' category is set to mature, including $900 billion from nonfinancial companies and $429 billion from financial services companies. Maturities of 'BBB' bonds from financial services companies peak in 2019, when $93.7 billion is set to mature. Maturities from nonfinancial corporates grow steadily from $143.7 billion in 2019 to a peak of $192.8 billion in 2022. In addition to the corporate bond debt, $515 billion in 'BBB' category bank debt is scheduled to mature through 2023; the majority of this bank debt is from revolving credit facilities.
Low Yields Have Fueled The Expansion And Supported Returns
Low interest rates and tight credit spreads have contributed to the rising share of 'BBB' issuance in recent years. Currently, a company pays a lower yield on a 'BBB' category bond than it would have paid on a 'AA' bond in 2007. With this low cost of funding, more companies have chosen to raise leverage--at the cost of a lower rating--to support shareholder-friendly actions such as stock buybacks and acquisitions (see Chart 2).
The Search For Yield Has Helped Bonds In The 'BBB' Category Outperform Higher-Rated Ones
As interest rates have begun to rise, the higher yields of 'BBB' category bonds have bolstered the category's performance relative to other investment-grade categories. Total returns for the 'BBB' category beat those of 'A' over the trailing 12-, 24-, and 36-month periods. Even though year-to-date total returns for the 'BBB' category are negative (negative 2.54% through June 30), they remain higher than the total return of negative 3.2% for the 'A' category (see Chart 3).
The additional yield for the 'BBB' category over the 'A' category has helped to cushion 'BBB' returns as interest rates have been rising. Furthermore, accommodative credit conditions and steady economic growth have supported above-average credit stability from the 'BBB' category, which has also bolstered returns, as downgrades and defaults from the category have been below historical averages in recent years. As of the end of June, the average yield for a 'BBB' category bond with a 10-year maturity was 4.6%, roughly 61 bps higher than that of an 'A' rated bond. While the higher yields from 'BBB' compensate investors for higher credit risk, the category has been more stable than usual in recent years. No 'BBB' U.S. companies have defaulted since MF Global Holdings Ltd.'s default in 2011, and the annual downgrade rate for the 'BBB' category has averaged below 2% since 2011, well below its long-term (since 1981) weighted average of 4.5%.
Given that 'BBB' corporate bonds typically have longer maturities than speculative-grade ones, it's not surprising that investment-grade yields and spreads have risen since the start of the year. This has been in reaction to the Fed raising short-term interest rates as well as Treasury yields breaking past 3%. Nevertheless, the current 10-year 'BBB' spread level could be somewhat elevated from economic and market-based standpoints (see Chart 4). Our estimated 'BBB' spread level is based off the purchasing managers' index, VIX, and the year-over-year change in the M2 money supply. This estimate has the 'BBB' 10-year bond spread 41 bps below the actual reading of 173 bps. This--along with a protracted period of favorable financing conditions (see Table 1)--informs our belief that while in its late stages, the current credit cycle could sustain a backdrop of moderate lending conditions and healthy liquidity through the first half of 2019. Our economists are also expecting GDP growth in the U.S. of 3% for this year and 2.5% in 2019, as economic data remains healthy. Their current recession odds are currently low--between 10% and 15% through the first half of 2019.
|U.S. Financing Condition Indicators|
|Tri-party Repo Market--size of collateral base (Mil. $)||x||1,914.32||1,877.74||1,591.71|
|Three-month financial commercial paper yields (%)||x||2.15||1.25||0.57|
|Three-month nonfinancial commercial paper yields (%)||x||2.10||1.17||0.45|
|10-Year Treasury yields (%)||x||2.85||2.31||1.49|
|Yield curve (10-year minus three-month) (bps)||x||92.0||128.0||123.0|
|Yield-to-maturity of new corporate issues rated 'BBB' (%)||x||4.46||3.40||3.39|
|Yield-to-maturity of new corporate issues rated 'B' (%)||x||7.49||7.34||7.44|
|10-year 'BBB' rated secondary market Industrial yields (%)||x||4.55||3.92||3.99|
|Five-year 'B' rated secondary market Industrial yields (%)||x||6.89||6.28||8.44|
|10-year investment-grade Corporate spreads (bps)||x||143.9||135.4||186.5|
|Five-year speculative-grade Corporate spreads (bps)||x||332.3||376.5||604.7|
|Speculative-grade Corporate bond deals undersubscribed, 12-month average (%)||x||17.8||14.5||15.7|
|Fed Lending Survey For Large And Medium-Sized Firms¶||x||-11.3||-2.8||11.6|
|S&P Global Ratings corporate bond distress ratio (%)||x||5.1||7.4||17.1|
|S&P LSTA Index distress ratio (%)||x||2.4||3.3||7.7|
|New-issue first-lien covenant-lite loan volume (% of total, rolling three-month average)||x||76.9||67.2||78.0|
|New-issue first-lien spreads (pro rata)||x||325.0||339.6||350.0|
|New-issue first-lien spreads (Institutional)||x||371.8||382.9||420.6|
|Amendments (number, rolling 12 months)||x||95||213||182|
|*Data through June 30. ¶Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices For Large And Medium-Sized Firms; through first quarter. Sources: IHS Global Insight, Federal Reserve Bank of New York, S&P LCD, and S&P Global Fixed Income Research.|
Greater Opportunities Have Led To Increased Investor Concerns
With funding costs low and companies taking on additional debt to fund share buybacks, capital expenditures, and acquisitions, U.S. companies' leverage has increased. The median ratio of debt to EBITDA for U.S. investment-grade nonfinancial companies has risen to 3.1x in 2017 from 2.8x in 2012. Notably, these leverage statistics include all nonfinancial sectors, including real estate and regulated utilities, both of which can support higher levels of leverage at a given rating category under our criteria due to the predictable nature of cash flows (see Chart 5).
However, the cost to service this debt has declined, as interest rates have remained low and financing conditions have remained accommodative. Even though U.S. investment-grade nonfinancial companies' debt level has increased, they have improved their interest coverage ratios. In addition, the U.S. real GDP has been growing at an annual pace of over 2% in 2017 and 2018, and corporate profitability has improved, even as interest rates have remained near historical lows. Although leverage has risen, the cost to service that debt has fallen relative to earnings.
With interest rates rising and companies carrying a heavier debt load, companies face the risk that credit quality could weaken as funding costs rise.
Why Downgrades Matter For 'BBB' Debt: Higher Funding Costs And Less Credit Availability
When an investment-grade bond is downgraded to speculative grade, typically yields rise, bond prices fall, and the issuer's funding costs increase. Furthermore, some investors could be forced to sell debt that is downgraded to speculative grade from investment grade. The market for speculative-grade debt is smaller and less liquid than the investment-grade market, as speculative-grade debt has a smaller pool of potential investors due to limits on the amount of speculative-grade debt that can be held.
Currently, the composite spread for a 'BB' bond (with a 10-year maturity) is 124 basis points (bps) wider than that of a 'BBB' bond. While the difference between 'BB' and 'BBB' bond spreads has mostly been 100 bps-200 bps, it typically widens during periods of market stress and volatility. In about 20% of observations, we see the spread widening to 200 bps–250 bps, and during the height of credit stress in 2009, the spread reached its widest point: 457 bps.
With a smaller pool of speculative-grade investors and the potential for forced selling when a company is downgraded from investment grade, the downgrade of a large amount of investment-grade debt can cause spreads and volatility to rise across the speculative-grade market. One of the biggest such shocks was when both General Motors Corp. and Ford Motor Co. were downgraded to the 'BB' category in May 2005. At the time, these two companies were among the largest corporate borrowers in the world, and these downgrades affected over $400 billion in debt. The amount of speculative-grade debt in the market swelled with this influx of recently downgraded debt, and volatile spreads nearly doubled for speculative-grade bonds in the first half of the year. Speculative-grade bond spreads surged up 200 bps over just two months--to 450 bps in May 2005--as the amount of speculative-grade debt in the market swelled. However, as investors adjusted to this supply shock, spreads receded, falling back below 300 bps by August 2005.
The 'BBB' Category's Default Risk Is Low In the Near Term But Rises Over A Longer Horizon
Often the key risk an investor faces when holding debt rated 'BBB' is the risk of a downgrade and a subsequent decline in the bond price, as 'BBB' rated issuers seldom default over the course of a year. Since 1981, most years have had no defaults from 'BBB' category issuers. Most 'BBB' defaults have occurred during cycles of heightened credit stress, such as in the aftermath of the bursting of the technology and telecommunications bubbles, when the 'BBB' default rate climbed to 1.3% in 2002. Even though there have been periodic defaults from 'BBB' category issuers, the default rates rise exponentially for lower rating categories. The 'BBB' long-term, one-year weighted average default rate (since 1981) is 0.21%, less than a third of the one-year weighted averaged default rate for the 'BB' category (0.78%), and less than the 3.78% one-year weighted average default rate for the 'B' category.
While the risk of a 'BBB' default is low in any given year, the risk rises over a longer time horizon. Over a three-year horizon, the three-year weighted average default rate for a 'BBB' category issuer is near 1%, while the 10-year weighted average default rate is close to 5%. However, over these longer time horizons, most of the companies that eventually defaulted were first downgraded to speculative grade, and in most cases this happened several years before their eventual default.
|Average U.S. Corporate Transition Rates Over The One-, Two-, And Three-Year Horizons (1981-2017)|
|D--Default. NR--Not rated. Sources: S&P Global Fixed Income Research and S&P Global Market Intelligence's CreditPro®.|
Fallen Angels And 'BBB' Downgrade Risk Are Rising But Are Still Off All-Time Lows
On average, 4.5% of U.S. companies that are rated 'BBB' become fallen angels, which means they are downgraded into the speculative-grade category over the course of the year. However, the pace of 'BBB' downgrades has slowed considerably in the years since the financial crisis. 'BBB' issuers have shown above-average stability in recent years, as companies have benefitted from steady economic expansion in the U.S. The trailing four-quarter downgrade rate for 'BBB' issuers has fallen to 1.36% in March and has remained below-average since 2010. During the most recent credit cycle, the downgrade rate for 'BBB' issuers peaked at 7.6% in 2009, and this was lower than the peak of 9.2% in 2002 following the bursting of the bubbles in technology and telecommunications.
Over a three-year horizon, the average upgrade rate for a 'BBB' issuer is nearly equal to that of downgrades at nearly 9%. However, for 'BBB' issuers, the risk from a downgrade typically outweighs the reward from an upgrade, as investors demand higher yields to compensate them for the risk of holding a speculative-grade bond (see Chart 7).
This is not to say that the 'BBB' category has not experienced periods of stress severe enough to cause large deterioration in credit quality (see Chart 8). In general, multi-notch downgrades into speculative-grade ratings from within the 'BBB' category are rare, and the percentage of ratings that take such a path has been falling over time. Unsurprisingly, these downgrades hit a recent peak in 2009 during the global financial crisis, when 37 'BBB' issuers received downgrades of more than one notch. Consistent with the property and financial assets bubble nature of that recession, 25 of those 37 came from financial services, and another five were from real estate. This represented 5.35% of the issuer base of firms rated 'BBB' at the start of 2009, and this ratio of multi-notch downgrades from 'BBB' to speculative-grade has averaged a modest 0.86% since hitting 1.5% during 2016.
Looking ahead, the current pool of companies most at risk of a downgrade to speculative grade is also small compared to the full population of 'BBB' issuers. While 'BBB+' and 'BBB' rated issuers sometimes are downgraded to speculative grade, we consider issuers rated 'BBB-' with negative outlooks or ratings on CreditWatch with negative implications, to be the most likely to be downgraded to speculative grade from investment grade, and we refer to these issuers as potential fallen angels. There were 28 such companies in the U.S. as of July 9, 2018, and these issuers have less than $90 billion in associated debt. A list of the current potential fallen angels is included in the appendix (see Table 3).
Even though the number of potential fallen angels is about average relative to the size of the 'BBB' category, the number of potential fallen angels has risen since the beginning of 2017, and collectively these companies are associated with an increasing amount of debt (see Chart 9). In April, the number of U.S. corporate potential fallen angels rose above 30 for the first time since 2010. By June 2018, U.S. potential fallen angels were associated with $96 billion in debt, up from about $32.5 billion at the all-time low in 2012. Several of the new potential fallen angels added in 2018 are business development companies from the financial institutions sector that face increased asset-coverage requirements from a recent change in regulations. Although the number of potential fallen angels has been rising, the current level remains well below the highs reached during stress periods in 2004 and 2009.
The Structural Drivers Of 'BBB' Credit Growth In The Capital Markets
The amount of 'BBB' category corporate bond debt outstanding has nearly doubled over the past five years and now exceeds $3 trillion. A changing composition of 'BBB' issuers and attractive financing conditions have led to this rise (see Chart 10).
However, despite the modest changes in the number of 'BBB' companies, the composition of those issuers has changed, and these companies now account for a growing portion of investment-grade issuers. The 'BBB' category accounted for the majority (51%) of U.S. corporate investment-grade issuers for the first time in 2009, and the 'BBB' share has remained above 50% since.
Downgrades of a small number of issuers with considerable debt outstanding had an outsized impact on the debt composition of the 'BBB' category. The largest shift has been the influx of nearly $600 billion in debt from financial services sectors in 2015, when the bank holding companies of Bank of America Corp., Citigroup Inc., The Goldman Sachs Group Inc., and Morgan Stanley were each downgraded to the 'BBB' category.
The amount of 'BBB' category U.S. corporate bond debt swelled by 55% in 2015, following S&P Global Ratings' downgrades of several systemically important financial institutions. The downgrades reflected progress that the companies had made toward adopting resolution programs--or so-called living wills--that were required under Dodd Frank regulation. With banks establishing these living wills, S&P Global Ratings lowered its ratings on the banks' nonoperating holding companies to reflect the diminished likelihood of extraordinary government support to the banking sector.
Furthermore, downgrades of AT&T Inc. (in 2015) and Verizon Communications (in 2013) brought over $300 billion in telecommunications debt into the 'BBB' category.
Because these downgrades have brought some of the largest corporate issuers into the 'BBB' category, the financial services and telecommunications sectors now account for much of the growth of the 'BBB' issuance volumes. The share of 'BBB' issuance from industrials and utilities has fallen to 44% in 2017 from 80% in 2012, as issuance from financial services and telecommunications is making up a growing share of issuance.
With more financial institutions and telecommunications companies included in the 'BBB' category, a growing share of investment-grade bond issuance is rated 'BBB'. In 2017 and the first half of 2018, 'BBB' issuance accounted for more than half of investment-grade issuance. This is markedly higher than in 2006-2008, when 'BBB' issuance accounted for less than 20% of investment-grade issuance.
With 'BBB' issuance growing as a share of investment-grade issuance volumes, we expect the 'BBB' category to continue to grow as a share of U.S. corporate debt. While historical default risk for 'BBB' issuers is relatively remote, a downgrade to speculative-grade can be costly for both issuers and investors. Rising interest rates--coupled with growing debt obligations--could present further challenges on the horizon, but at this time we do not foresee a sudden negative shift in borrowing costs or financing conditions. The current credit cycle is in its later stages but should manage to continue through the first half of 2019 with marginal increases in borrowing costs for 'BBB' issuers, rather than a situation characterized by a sharp rise in interest rates and a marked reduction in liquidity.
|U.S. Corporate Potential Fallen Angels|
|Issuer||Subsector||Outlook/CreditWatch status||Rated debt amount (Mil. $)|
|Trinity Industries Inc.||Capital goods||Watch Neg||850|
|Brunswick Corp.||Media and entertainment||Watch Neg||475|
|Viacom Inc.||Media and entertainment||Watch Neg||12,450|
|Flowserve Corp.||Capital goods||Negative||1,388|
|BlackRock Capital Investment Corp.||Financial institutions||Negative||150|
|Corporate Capital Trust||Financial institutions||Negative||500|
|Euronet Worldwide Inc.||Financial institutions||Negative||403|
|Hercules Capital Inc.||Financial institutions||Negative||578|
|New York Community Bancorp Inc.||Financial institutions||Negative||240|
|PennantPark Investment Corp.||Financial institutions||Negative||318|
|Prospect Capital Corp.||Financial institutions||Negative||3,336|
|Solar Capital Ltd.||Financial institutions||Negative||225|
|TCP Capital Corp.||Financial institutions||Negative||375|
|TPG Specialty Lending Inc.||Financial institutions||Negative||380|
|Keysight Technologies Inc.||High technology||Negative||2,200|
|Motorola Solutions Inc.||High technology||Negative||6,241|
|Trimble Inc.||High technology||Negative||900|
|Xerox Corp.||High technology||Negative||5,275|
|Government Properties Income Trust||Homebuilders/real estate companies||Negative||950|
|Washington Prime Group Inc.||Homebuilders/real estate companies||Negative||1,893|
|Discovery Inc.||Media and entertainment||Negative||17,086|
|Oceaneering International Inc.||Oil and gas||Negative||1,100|
|Bed Bath & Beyond Inc.||Retail/restaurants||Negative||1,500|
|Macquarie Infrastructure Corp.||Utilities||Negative||2,829|
|Midcontinent Express Pipeline LLC||Utilities||Negative||450|
|Ohio Valley Electric Corp.||Utilities||Negative||695|
|Plains All American Pipeline L.P.||Utilities||Negative||18,782|
|Data as of July 9, 2018. Source: S&P Global Fixed Income Research.|
- When The Cycle Turns: How Have M&A Transactions In Consumer Products Performed? July 25, 2018
- When The Cycle Turns: U.S. 'BBB' Corporate Profiles Remain Firm Despite Rising Debt, July 25, 2018
- When The Cycle Turns: Will Consumer Companies' M&A-Related Debt Result In An Exodus From Investment Grade? July 25, 2018
- Global Fallen Angels: The Telecommunications Sector Continues To Contribute To The Fallen Angels Tally, July 6, 2018
- The U.S. Speculative-Grade Corporate Default Rate Could Fall To 2.5% By March 2019 As Favorable Financing Conditions Persist, May 22, 2018
- 2017 Annual U.S. Corporate Default Study And Rating Transitions, April 25, 2018
This report does not constitute a rating action.
|Global Fixed Income Research:||Diane Vazza, Managing Director, New York (1) 212-438-2760;|
|Nick W Kraemer, FRM, Senior Director, New York (1) 212-438-1698;|
|Evan M Gunter, Director, New York (1) 212-438-6412;|
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