Extended Summer for Potential Bond Rating Upgrades
Over the summer, more entities joined the ranks of those poised to benefit from potential upgrades, an attestation to continued improvement in credit quality globally. Issuers’ efforts to improve balance sheets, streamline operations, and improve capital structures have enhanced profitability, thereby positioning them well to take advantage of improving demand conditions. Even though wobbly economic data in recent weeks have led to a flattening of the yield curve, raising questions about growth and earnings prospects, some relief is expected from a slow trajectory in interest rates, which will keep borrowing costs favourably low for many issuers.
Entities that either have a positive outlook or have ratings that are on CreditWatch with positive implications are a good leading indicator of actual upgrades. As of 27 September, 305 entities appear well placed for potential upgrades, a 5 per cent increase over the 290 reported in June. Of the 305 entities listed with either a positive outlook or with ratings on CreditWatch with positive implications across all rating designations from AA+ to B-, banks, media and entertainment, and telecommunications are especially well placed for potential upgrades.
Issuers in the banking and telecommunications sectors were dispersed around the globe, whereas entities from the media and entertainment sector were primarily located in the US. Since the June report, the sectors that have shown the biggest net increase in the number of potential upgrades are metals, mining and steel, capital goods, and retail/restaurants. The highest potential for upgrades was seen in the B+ rating designation, which accounted for 20 per cent of total pool of potential upgrades. Speculative-grade rated entities (BB+ or below) appeared more likely to benefit from upgrades, accounting for 61 per cent of the total number of entities.
Looking globally by sector, the banking sector continued to account for the largest number of issuers on the current potential upgrade list, with 45 issuers (see Chart 1). This is a small decrease from the report published on 14 June, when the banking sector accounted for 47 entities. Next in line globally among the potential upgrades were the media and entertainment sector (23 issuers) and the telecommunications sector (22 issuers).
Within banking, the US continues to lead in terms of the number of entities. The industry is in the midst of consolidation, especially among regional banks, which has spurred optimism. Of the 13 US banks currently on the potential upgrade list, seven are either in the process of merging or have recently successfully integrated their acquisition, with the goal of creating entities with improved geographic and business line diversity. Even though core operating performance among regional banks declined in the second quarter relative to the first, traditional banking operations at these banks continue to do well, and core deposit growth remains robust. Asset quality also continues to improve even though pressure on net interest margins remains, combined with the risk of lower mortgage originations.
Of the 23 entities in the media and entertainment sector on the potential bond upgrade list, more than 80 per cent are from the US. Although trends within the sector differ by specific market, the sector faces a stronger 2004 after a mixed and halting recovery in 2003, but positive trends could falter in 2005 if the economy runs out of steam. Nearly one-third of the entities in this category belong to the gaming sub sector. The US gaming industry performance has been solid through the first half of 2004, and this trend is expected to continue in the near term. The positive near-term outlook stems from solid industry fundamentals, which are driven mainly by a relatively healthy US economy, overall modest supply growth, and further acceptance of gaming as a form of entertainment by the US consumer.
Potential upgrades in the telecommunications sector are dispersed across the globe, with nine in the US, six in Europe, four in Eastern Europe/Middle East/Africa, and three in Asia Pacific. In the US, most of the entities likely to be upgraded are wireless companies in the speculative-grade segment. During the economic downturn, US telecommunications entities made efforts to streamline finances and operations, improvements that are expected to pay off into net free cash flows as the economy rebounds.
By contrast, in Europe, five out of six of the European potential upgrades are from the investment-grade segment. In line with the trend initiated almost two years ago, Europe’s largest integrated telecoms operators overall delivered sound Ebitda growth in the first half of 2004 as well as solid, growing free cash flow given that capital expenditures remained close to historical lows. Operating margins were also higher, mostly owing to domestic cost cutting and economies of scale at international operations. Improvements in creditworthiness remain possible, provided that financial policies are predictable and a substantial portion of cash flow is used for debt reduction.
In addition to the top three sectors, which accounted for 30 per cent of the total list of potential upgrades, three other sectors featured prominently on the current list of potential upgrades. Healthcare was listed with 20 issuers, and capital goods and high technology were listed with 19 issuers each.
Since the June report, the sectors that have shown the biggest net increase in the number of potential upgrades are metals, mining and steel (which rose by eight issuers), and capital goods and diversified subcategories (which rose by three issuers each). Aerospace/defence increased by four issuers, but the number of entities in this category remains small. Within metals, mining and steel, potential rating upgrades are centred in the US – which accounts for more than half of the total increase – where improvement is likely to be driven by rebounding metals prices and improving demand in some regions. Still, upgrade potential will be constrained by substantially increased capital expenditures to replenish reserves or increase production.
Cyclical sectors like capital goods are being bolstered by factors such as stronger sales, an improved economic outlook, and strengthening earnings/cash flows after several years of rationalizing operations and cost-cutting activities. Among diversified companies, Japanese general trading companies are well positioned for upgrades based on gradually improving financial profiles and successful risk management between investment and lending activities.
Nine sovereign entities were included in the list of potential upgrades, with four recorded in the AsiaPacific region, three in Eastern Europe/Middle East/Africa, one in Europe, and one in Latin America. Six of the nine sovereigns are rated investment grade, and the remainder are rated speculative grade. The B+ rating designation showed the most potential for rating upgrades, accounting for 20 per cent of the total pool of potential upgrades (see Chart 2). By rating category the preponderance of potential upgrades appeared in the B rating category – including the B+, B, and B- rating designations – which accounted for 37 per cent of the total pool of potential upgrades.
Of the 305 issuers on the current list, 39 per cent are investment grade (BBB- and above), and the remaining 61 per cent are speculative grade (BB+ and below). The concentration in the speculative-grade segment is not surprising because speculative-grade ratings are generally associated with greater volatility. The proportion of potential upgrades in the speculative-grade segment remains unchanged since the last report in June, when 61 per cent of issuers were speculative grade.
As of 27 September, a global total of 305 entities appeared most likely to benefit from potential upgrades across all rating designation from AA+ to B-. These entities either had ratings on CreditWatch with positive implications or had a positive outlook. The current list includes a net increase of 15 issuers compared with that of 14 June 2003, when 290 issuers were listed as potential upgrades. Since the previous publication, 83 additional issuers were added to the list. The majority (70) of these issuers were included because of an upgrade in outlook/CreditWatch status but no rating change. Six issuers now have rated debt, three issuers made the list by coming to the market with a first debt offering, and four were added as a result of a ratings upgrade. Of the 68 issuers that fell off the June list, 33 entities were upgraded, 21 experienced a change in outlook/CreditWatch status, and 14 are no longer rated.
Of the 33 issuers that dropped off the June list because of an upgrade, 13 were from the broad-based industrials category, 12 were from the banking sector, three from sovereigns, two from financial institutions, two from utilities, and one from telecommunications.
Geographically, the US continues to account for the largest number of entities listed for potential upgrade, with 187, but that concentration in part reflects the larger rated population in the US (see Table 1). The majority of additions since June also come from the US, which now accounts for 61 per cent of the total list of potential upgrades versus 59 per cent in June.