Ratings: A 25-Year March to Junk

S&P says aggressive financial policies and rising demand for high-yield debt have pushed nearly 50% of companies below investment grade

From Standard & Poor's RatingsDirect

Spurred by strong risk appetite and ample liquidity, the universe of U.S. high yield bond issuing entities continues to expand, steadily inching the U.S. ratings mix toward a 50-50 split of investment-grade and speculative-grade issuers.

The non-financial issuer universe is already 61% speculative grade, a feature that stands in stark contrast to Europe, where firms are predominantly investment grade. However, both regions have seen aggregate credit quality slip during the past decade, as the low interest rate environment and elevated investor risk tolerance have increasingly encouraged speculative grade firms to directly tap into extremely liquid financial markets, eschewing the more onerous bank lending route.

The high-yield investor base has also continued to broaden and deepen. Low long-term interest rates and a receptive market for long-term debt have allowed firms to judiciously lengthen the maturity of their debt and lock in low interest rates, giving them more flexibility over their balance sheets than before.

Record High

Strong shareholder focus, coupled with stiff global competition, requires a far more aggressive financial strategy on the part of firms, suggesting that managing to a lower credit quality rating may be a better management strategy.

As of Sept. 30, the speculative grade rated share of Standard & Poor's Ratings Services parent and subsidiary level issuers stood at a record high of 49%, compared with 48% at the end of 2005 and a low of 28% in 1992. This has lowered the overall median issuer rating to BBB-, from BBB+ in 1996 and A- in 1992.

Currently, 12% of financial issuers and 61% of nonfinancial issuers are speculative grade. In contrast, the lower receptivity of high yield bond issuers in Europe has limited their share to a mere 17%, with 33% for non financial firms and a scant 2% for financial entities.

Rise of the B's

The U.S. investment grade segment is dominated by financial institutions, as mergers and acquisitions (M&As) have created enormous financial entities with huge funding appetites. The relative dearth of investment-grade industrial entities can be traced to the increased incidence of "fallen angels"—companies that have dropped below investment-grade status—along with substantial M&A activity in the industrial and utility sectors, which has drastically shrunk the number of issuing entities.

Two ratings themes stand out for the U.S. nonfinancial sector: the declining prominence of AAA rated outfits—also seen in Europe—and the simultaneous rise of the B rated concern. There are only six parent AAA-rated non financial entities left in the U.S., compared with 24 in 1998, while the 821 B-rated parent and subsidiary level issuers now comprise 35% of all nonfinancial firms and 27% of total issuers.

The influx of speculative grade new issuers is continuing at a strong clip. This year, 76% of U.S. new issuers have been speculative grade, with 61% at the B level.

Warts and All

The U.S. ratings mix has progressively downshifted since the investment grade percentage peaked at 72% in 1992. Since 2000, the investment grade universe has dropped by 13.2% to 1,587 issuers, while the speculative grade segment has climbed by 17.8% to 1,504 issuers. In part, this represents the usual confluence of events in the issuer universe: downgrades exceeding upgrades, with more fallen angels than rising stars (i.e., companies poised for a move from junk to investment grade), and, of course, defaults.

However, the high level of risk tolerance, with strong demand for spread product, has caused more speculative-grade issuers to enter the bond-borrowing sphere, a phenomenon also apparent in Europe. While a host of mergers and acquisitions have reduced the number of investment grade entities, the heightened shareholder-supportive stance on part of firms also suggests that firms may be more accepting of a lower credit quality status to maintain shareholder value rather than simply aim at maintaining a high credit rating.

The high-yield investor base also continues to broaden and deepen.