Chandler Bond Market Review

Corporate Credit Ratings – Risk of Downgrades Has Increased

Although corporate credit fundamentals of many high grade bond issuers have improved significantly since the financial crisis and recession, we believe the risk of an increase in the number of corporate credit rating downgrades has recently become more elevated.  In some cases, the weakening of corporate credit is directly tied to the rising debt levels of sovereign issuers.  For this reason, we believe the outcome of the European debt crisis and the U.S. presidential election later this year (which should provide insight into the fiscal budget outlook for the U.S. and potentially impact the U.S. credit rating), will have a meaningful influence on corporate credit ratings.

Pressure on some corporate credit issuer’s fundamentals (from industrials to consumer-related corporations) is rising because of the European sovereign debt crisis, which has strained the overall European economy, and has begun to hinder revenues and earnings of many global corporations.  For example, Proctor & Gamble, Ford, and Dover are among some of the companies that have recently lowered their earnings guidance, in part because of lowered demand in Europe.  Should the European Union fail to find a resolution to their fiscal crisis, we expect that the corporate credit fundamentals of companies with significant exposure to Europe in particular will come under more pressure.

However, credit ratings of banks and financial institutions are most directly tied to sovereign debt ratings, and likely face the most immediate pressure.  Although the intrinsic credit-worthiness of many domestic banks and financial institutions has improved over the past few years, due to increased oversight, higher capital levels, and stronger balance sheets, the implied support from the government has declined.  As the credit ratings of many sovereign debt issuers have declined due to soaring government debt levels and poor fiscal management, the credit-worthiness of their homeland banks and financial institutions has also weakened.  This is because most banks and financial institutions receive credit rating boosts from implied government support (i.e. in the event of a financial crisis or liquidity event, it is assumed that the government would step in and provide a backstop).  Over the past year, we have seen several sovereign credit rating downgrades, which have negatively impacted the credit ratings of many banks.

In the month of June, Moody’s downgraded fifteen global banks, including high quality issuers such as JP Morgan, Credit Suisse, and HSBC.  The downgrades were anticipated by Chandler’s portfolio management team, and were driven in part by the perception of diminished government support, and in some cases by the banks’ exposure to Europe.  S&P has recently taken similar action on financial institutions in Spain due to a decline in implied support from the Spanish government.  Recall that S&P downgraded the U.S. sovereign credit rating in August last year, and subsequently lowered the credit ratings of some financial issuers whose ratings reflected government support.

S&P, Moody’s, and Fitch each maintain a Negative Outlook on the sovereign credit rating of the U.S.  Any potential further downgrade of the U.S. sovereign debt rating would most likely put additional downward pressure on the credit ratings of domestic banks.  Moody’s has indicated that they plan to update their view on the U.S. after the presidential election.  Outside of the U.S., we believe the potential for further sovereign credit rating downgrades in Europe remains high, putting foreign banks at risk for further downgrades as well.

During the second quarter of 2012, the number of credit rating upgrades by Standard & Poor’s outnumbered downgrades (S&P upgraded thirteen companies and downgraded five).  However, in a report released earlier this month, S&P said that it expects downgrades may outnumber upgrades in the near to intermediate term, since current rating outlooks are somewhat negatively biased.  According to S&P, the telecommunications services and financials sectors have the highest downgrade potential over the near to intermediate term. In a separate report, S&P also noted that their rating outlooks remain negative for the majority of large complex banks and trust banks.  For most banks, they said that their outlooks reflect the negative outlook on the sovereign rating on the U.S. and the likely impact that a potential downgrade of the U.S. would have on the support factored into bank ratings.  Overall, S&P has indicated that the number of potential corporate credit rating downgrades is currently at its highest level since August 2010.

Looking ahead, we believe developments in Europe, and secondarily the outcome of the U.S. presidential election, will have a significant influence on the global and domestic economy, as well as sovereign and corporate credit ratings.  Because we think the downward pressure on credit ratings may be rising, the team at Chandler has taken a more conservative stance in selecting securities for our client portfolios in recent months, and we believe a more defensive posturing is prudent over the near- to intermediate-term.

– Shelly Henbest, VP, Credit Analyst

S&P Downward Ratings Migration

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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