Downgrades during the corona crisis
In March, the corona crisis unfolded in the Western world. Several governments have chosen to implement a so-called "lockdown" to slow down or prevent spread of the coronavirus. However, these lockdowns have caused huge problems for a significant number of companies. What do the resulting credit rating downgrades in different sectors show?
As a result of the corona crisis, companies are seeing their turnover declining, while fixed costs such as rent and salaries remain. For example, in most European countries, shops and restaurants are closed, and travel agents and airlines are forced to cancel holidays and flights. Gas and oil companies are facing a drop in demand due to the lower consumption of fuel by both consumers and industry and the disagreement between OPEC countries, Russia and the United States. Car manufacturers are facing a decline in demand due to the uncertainty about the economy, which in turn causes consumers to postpone investments or even lose the ability to invest. As a result, unemployment is rising, which in turn leads to another fall in consumption. In the United States, the unemployment rate has already risen by more than 10% in the past month.
Link to corona cases
Lower turnover in combination with economic uncertainty can lead to an increase in credit risk for companies. Corporate credit ratings are used to determine the extent to which companies are able to meet their financial obligations. These ratings are an indicator of developments in creditworthiness and market uncertainties. The graph below shows the number of downgrades of the corporate family rating (CFR) in the United States, Europe, Middle East and Africa by rating agency Moody's in the past two months. The findings show that there is a link between the number of downgrades and the number of confirmed cases of Covid-19 in the world. However, there are significant differences in downgrades by industry.
By comparing the number of downgrades between sectors, we can determine which sector is hit the hardest. The top 10 affected industries according to Moody's CFR downgrades are depicted in the graph below. The first wave of downgrades resulting from the corona crisis is observed on March 20 in the energy, oil and gas industry, due to the low demand for oil and gas. Consequently, prices declined largely. Furthermore, the business and consumer services were also hit in the first wave. A second wave is observed from March 25 to 27, which hits the gaming industry the hardest. These are mainly downgrades of casinos in the United States that we also observed during the crisis of 2008-2009. In addition, the automotive and retail industry were hit in the second wave. The reasons for this include consumers being unable to visit showrooms and shops and unwilling to make large purchases in times of financial uncertainty. The third wave of downgrades occurred on March 27 in the technology industry and the hospitality industry. Finally, from the beginning of April, a particularly significant increase in the number of downgrades is observed in business and consumer services and the energy, oil and gas industry.
It is important to note that the absolute number of downgrades in a sector does not accurately reflect the situation due to size differences between sectors. To determine the actual effect in a sector, the relative number of downgrades in a sector are compared. The graph below depicts the percentage of companies in a sector that were impaired over time. This shows that the gaming, entertainment and the catering industry experienced the greatest number of downgrades relatively and are therefore proportionately affected the most by the corona crisis in terms of corporate credit rating downgrades.
While governments are spending billions on financial aid for companies, rising numbers of corporate credit rating downgrades are expected. It remains to be seen which industry will appear in the next round of downgrades. With an average lead time of 2 to 3 weeks in rating committees, another round of downgrades could be expected to spike in May if the corona virus continues to spread and the lockdown measures are prolonged.
The question is how asset managers will respond to the downgrades. Will it lead to the sale of shares or debts of downgraded companies or will asset managers keep the faith in these companies? Downgraded companies will have higher financing costs, which could lead to the breach of covenants. This could lead to another round of downgrades and again higher financing costs. Companies face the risk of entering a vicious circle.