Fewer Downgrades Drive Credit Quality Moderation in Europe
In the first quarter of 2004, downgrade activity affecting financial and non-financial entities in Europe declined from its peak in the fourth quarter of 2002, matched by a substantial fall in the number of defaults. Both downgrades and upgrades receded from the level recorded a quarter earlier, resulting in a downgrade ratio of 59% in the first quarter vs. 62% a quarter ago. This year, credit quality should see some improvement amid expectations of weakly accelerating growth, although the stuttering advance suggests no sustainable gain will materialize until final demand for goods and services gains momentum. The significant payoff from balance sheet repair is largely done, and further enhancements in credit quality will hinge on growth kicking into gear, with concomitant improvements in profitability, retained earnings, and cash-flow generation. Moreover, a strengthening euro poses risks to export growth, even though strength would partially be offset if the European Central Bank (ECB) were to reduce interest rates.
European ratings activity continued to show a deceleration in negative tone with a substantial decrease in downgrades relative to the previous quarter (see Chart 1). The relative improvement in credit quality was led by a decline in downgrades rather than an increase in upgrades. The ratio of downgrades to total upgrades-downgrade ratio-fell to 59% in the first quarter of 2004, its lowest level since the second quarter of 1998. Previously, the downgrade ratio was 62% a quarter earlier and 98% four quarters ago. A total of nine upgrades and 13 downgrades were recorded in the first quarter, affecting long-term rated debt worth US$91.3 (€73.5) billion and US$44.0 (€35.4) billion, respectively. The total debt affected by upgrades is largely influenced by the upgrade of France Telecom S.A. on Feb. 18, 2004, which accounted for 58% of the total. Nevertheless, on a volume basis, upgrades exceeded downgrades for the second consecutive quarter in Europe.
Global credit quality also continued to show moderation in the first quarter of 2004, largely due to a deceleration in total downgrades relative to the previous quarter. The global credit ratio-ratio of downgrades per upgrade-for all financial and non-financial issuers fell to 1.3 in the first quarter, considerably lower than 1.6 in the previous quarter and 4.6 for the first quarter of 2003. Globally, a total of 85 upgrades and 108 downgrades were recorded in the first quarter. The rating actions affected long-term debt outstanding worth US$164.0 (€132.0) billion in upgrades and US$197.6 (€159.1) billion in downgrades. Most regions showed an improvement in corporate creditworthiness for the quarter, even though downgrades still outpace upgrades in the more economically developed regions (see Chart 2). In the U.S., downgrades as a share of total rating actions dipped to 64% from 71% for the previous quarter, and 79% a year ago. With 45 upgrades and 80 downgrades in the year to date, the U.S. share of total ratings actions remained steady at 65%. In Canada, the downgrade ratio increased to 70% from 60% in the fourth quarter of 2003, but below the 94% in the first quarter of 2003. Meanwhile, the downgrade ratio in Japan recorded 33% in the most recent quarter. Quarterly movements in Canada as well as Japan appear exaggerated due to the small size of the rated universe. By contrast, credit quality in the emerging markets maintained their positive momentum, with upgrades surpassing downgrades for the third consecutive quarter. The downgrade ratio in emerging markets fell to 17% from 29% a quarter earlier, driven especially by strength in the Eastern Europe/Middle East/Africa (EEMEA) and the Asia-Pacific regions.
In Europe, during the first quarter of 2004, upgrades and downgrades were broadly dispersed among a variety of sectors (see Chart 3). High technology showed the most positive momentum, with two upgrades and no downgrades. On the flip side, capital goods and utility sectors led the way for downgrades, each recording two downgrades and zero upgrades. The consumer products and insurance sectors, which recorded 42% of the downgrades in the previous quarter, stabilized and showed only one downgrade each for the first quarter of 2004. With six upgrades and nine downgrades, the majority of the rating actions were concentrated in investment grade category (‘BBB-‘ and above) rather than the speculative grade category (‘BB+’ and below). The investment grade category made up 68% of the total quarterly rating actions.
Europe tallied two fallen angels-issuers that have been downgraded to speculative grade (‘BB+’ and below) from investment grade (‘BBB-‘ and above)-in the first quarter of 2004, which affected debt outstanding worth US$1.9 (€1.5) billion. The two European fallen angels were Metso Corp., a Finland-based company specializing in the supply of process industry machinery and Valentia Telecommunications upc, an Ireland-based telecommunications operator. After record numbers of fallen angels at the end of 2002 and beginning of 2003, the first quarter of 2004 marks the third consecutive quarter with two or fewer fallen angels (see chart 4).
As of Mar. 31, six European entities were listed as potential fallen angels-these are entities that are rated ‘BBB-‘ and listed with either a Negative Outlook or a CreditWatch with negative implications. The media & entertainment and utility sectors had two potential fallen angels each, while insurance and consumer products accounted for one a piece.
Even as the number of fallen angels has dropped off, no rising stars have been recorded in Europe in the first quarter-these are issuers that are upgraded to investment grade from speculative grade. As of Mar. 31, there was one potential rising star-these are entities that are rated ‘BB+’ and listed with either a Positive Outlook or a CreditWatch with positive implications. The potential rising star is Switzerland-based engineering services company ABB Ltd., which stands to gain from the expectation that management has initiated the right steps to improve the group’s still weak cash flow generation in the foreseeable future, and reduced event risk from asbestos-related litigation.
The EU twelve-month rolling speculative-grade default rate displayed a dramatic drop to 1.2% at the end of March vs. 5.10% six months ago and 12.95% a year ago. The March rate is the lowest since April 2001. Of the 12 defaults recorded globally in the first three months, only two occurred in the European Union (EU) affecting rated debt outstanding worth US$1.3 (€1.1) billion. 2 The default of Avon Energy Holdings-a U.K.-based electricity distributor-following its acquisition by Powergen U.K. PLC contributed US$1.1 (€0.9) billion, the largest global default in the year to date. The other default recorded in the year to date was Italy-based machinery component maker Italtractor ITM SpA, whose ratings were lowered to ‘SD’ on Jan. 22, 2004 after the company announced that it would not honor payments on selected debt obligations. As of Apr. 13, only one European entity (a Norway-based oil and gas contract drilling company) appeared on the “weakest links” list-these are issuers that carry a credit rating of ‘CCC’ or lower and are listed either with a Negative Outlook or a CreditWatch with negative implications.
Looking ahead, credit quality continues to be biased towards the negative. Of the 590 entities rated at the parent level in Europe as of Mar. 31, 22% were listed either with a Negative Outlook or a CreditWatch with negative implications, 70% were Stable, and 8% were listed with a Positive Outlook or a CreditWatch with positive implications. The Outlook and CreditWatch distribution shows slight improvement from the distribution as of Dec. 31, 2003, when 25% were listed with a Negative Outlook or a CreditWatch with negative implications, 67% were Stable, and 7% were listed with a Positive Outlook or a CreditWatch with positive implications.
The negative bias predominates in the speculative grade segment, which accounts for fewer than 20% of total ratings in Europe. In the speculative grade segment, 24% of entities were listed with a negative bias, compared with 21% for the investment-grade segment. Both segments, however, had equal proportions of entities listed with a positive bias (8%). This behavior is consistent with the one-year transition matrix displayed in Table 1, which demonstrates that on average (19812003 timeframe), speculative grade-rated issuers-both in Europe and globally-tend to experience greater ratings instability than their investment-grade counterparts.
Looked at by sector, insurance, consumer products, forest products and building materials, oil and gas services sector, and high technology were among the most vulnerable to potential downgrades, with 30% or higher of listed entities in each sector listed with a negative bias (see Chart 5). In the European insurance sector, financial strength has been weakened by investment-related losses and poor underwriting discipline in the late 1990s. Industry trends diverge broadly within the sector however, with trends being broadly positive in the non-life and reinsurance markets. Industry trends in life insurance remain negative, based on increasing regulation and margin pressures in the more developed markets. Investment spreads between available yields and policyholder guarantees and/or crediting rates are tight, asset management fees remain depressed, and fund values are lower. The negative outlooks in the European consumer products sector in most cases reflect the industry’s ongoing consolidation, pressures from the strength of the euro, and sluggish consumer demand in France and Germany.
Within the European forest products sector, factors such as continued weak market conditions in the near term and the weaker U.S. dollar over the past year are factors pressuring the credit quality of rated European forest products companies. In the building materials category, a significant number of outlooks remain negative, reflecting companies’ delays or difficulties in restoring more adequate financial profiles (Lafarge, Pilkington PLC, Sanitec), ill-timed re-leveraging policies (Grohe), or exposure to asbestos liabilities (Compagnie de Saint-Gobain S.A.). Issuers in high technology are beginning to emerge from their cyclical bottom, though recovery remains constrained by an intensely competitive environment.
Weakness in oil and gas is centered in the oilfield services sector, and among refining and marketing independents. Despite high crude oil prices and often below-target production growth at international companies, major economic uncertainties and international tensions led many exploration and production (E&P) companies to continue to rein in capital expenditures and services contracts. As a result, most European oilfield services companies have so far benefited very little from continuously favorable commodity prices over the past three-and-a-half years. As subcontractors of the oil and gas industry, most services companies saw their operating performance significantly affected by cost-saving measures at E&P companies, and their negotiating power remains weak. The outlook for refining and marketing independents reflects historically low refining margins and disappointing profitability.
On the flip side, issuers in the telecommunications and automotive sectors appear best poised to benefit from potential upgrades. Strong operating performances and substantial cash flow generation among investment grade telecommunications issuers in 2003 has set the tone for a substantial improvement in credit quality, based on steady and consistent debt-reduction efforts, better operating performance, and predictable financial policies. A positive concentration of outlooks in the automotive sector is consistent with improving cyclical prospects resulting in higher utilization rates. Still, even in those sectors that demonstrate positive trends, credit quality upside is likely to be limited as corporate treasurers in Europe target lower ratings-in the ‘A’ and ‘BBB’ category range-in order to optimally balance shareholder and debtholder interests.
Mikhail Katz contributed to this report.
1 Europe is defined to include the industrialized countries of Western Europe, and includes Austria, Belgium, Channel Islands, Cyprus, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Isle of Man, Italy, Liechtenstein, Luxembourg, Malta, Monaco, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the U.K.
2 Count includes rated entities as well as those that were not rated at the time of default.