The main conclusion was that positive trends in credit are likely to continue for the rest of the year, a view which we at TwentyFour share. One statistic that caught our attention was the ‘upgrade to downgrade’ ratio. The ratio simply divides the number of companies whose ratings have been upgraded by the number of companies that have suffered a downgrade during the quarter.
Since the start of the crisis downgrades have significantly outpaced upgrades, driven by deteriorating credit ratios and sovereign downgrades which automatically lower the ratings ceiling that companies can achieve.
In Q1 2014 this trend reversed and for the first time since 2008 we witnessed more upgrades than downgrades (the ratio came at 1.6x).
This is yet another reflection of the improvement we have seen in fundamentals over the last couple of years.
Companies have worked hard to improve their balance sheets and Central Bank actions have stabilised growth which in turn helps in closing government budget deficits.
This is now being translated into better credit ratings for companies and sovereigns (Spain was upgraded one notch to Baa2 in February and the rating is on positive outlook) as the upgrade to downgrade ratio shows.
As the sovereign ratings move up so do sovereign ceilings; in fact two of the upgrades in Q1 2014 were Spanish companies with sovereign linkages.
Ratings on negative outlook are decreasing while ratings on positive outlook are increasing which bodes well for future rating upgrades, although we note that negative outlooks almost double positive outlooks at the moment.
Default forecasts have also been revised down. Moody’s base case for 2014 Speculative Grade defaults in Europe is now just 2.01 per cent which is extremely low by historical standards, and not yet coupled with historically very expensive spreads.
We believe fundamentals will continue to improve as monetary transmission mechanisms in Europe continue to heal and growth rates slowly recover.
Outside of Europe markets are already pricing in future rate rises as monetary policy slowly normalises; this is due to economic improvement at the sovereign level, which in turn is driven by company performance.
This underpins our positive view for credit and we see this, coupled with a continued very low default rate, as the drivers that takes credit spreads from broadly “slightly rich of fair value” today to “very expensive” before this current cycle ends.
Naturally there are sectorial variances - for example, high yield corporate spreads are the most expensive to their historical averages, while bank subordinated bonds are still wide of their historic averages.
However all sectors should have room to improve as the economic data improves and the default rate remains at these ultra low levels, although clearly the big recovery trade is behind us and performance here in should also be driven more greatly by individual company performance.
In short, fundamentals continue to support credit performance, and the upgrade to downgrade ratio swinging back to the positive is just the latest reminder.