Pervasive Credit Deterioration and Significant Default Risk

S&P’s Annual Ratings Transition Analysis

Every year, S&P provides at their website an analysis of how their ratings change after 1, 3, 5, and 7 years, based upon their most recent 30 years of experience.  The table below summarizes the changes occurring after 5 years from their 2019 report.

Two Major Takeaways

1. Pervasive Credit Deterioration. Over five years, there is a substantial amount of deterioration in credit ratings for even BBB-rated companies (37%) and even more so for BBs (54%) and Bs (63%). Said another way, over five years, more than 3.4x as many BBBs deteriorate than improve their credit quality, while it is 3.9x for BBs and 5.3x for Bs. When you think about it, this deterioration is to be expected. Companies have relatively short lives.

2. Significant Speculative Grade Default Risk. S&P defines a default as a missed payment, a distressed debt exchange, or a bankruptcy filing, what we call a “Hard Default.” Any other kind of default, such as breaking a ratio or violating a covenant, is what we call a “Technical Default”. Given the general credit deterioration that happens over five years, we believe that the risk of a technical default must be at least equal to S&P’s hard default rate. So while BBB’s have a small 4% total default risk over 5 years, for speculative grade companies it is significant: 14% for BB’s and 36% B’s.

2019 S&P Transition Statistics

Rating Change in 5 Years BBB BB B
Upgraded 11% 14% 12%
Unchanged 52% 32% 25%
Downgraded 10% 12% 3%
Non-Rated (a) 25% 35% 42%
Defaulted (b) 2% 7% 18%
100% 100% 100%
(a)  Companies become non-rated for many, but mostly bad, reasons,  so we view it as evidence of credit deterioration.
(b)  A “hard” default: payment default, distressed debt exchange or a bankruptcy filing
Changes over 5 Years BBB BB B
Ratio of Deteriorated/Upgraded Ratings
Deteriorated 37% 54% 63%
Upgraded 11% 14% 12%
Deteriorated/Upgraded 3.4x 3.9 x 5.3x
Expected Default Risk over 5 Years
S&P Hard Default 2% 7% 18%
DCS Technical Default 2% 7% 18%
Total Default Risk 4% 14% 36%

Next Steps

1. A default is not trivial. Learn how the cons