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Corporate Supply & Flows (OCTOBER 16)

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CreditSights: The Week In Credit

Given that ratings activity is a lagging indicator, it is hardly news that the trends here are improving. Yet by several measures, the three months ending in September delivered the best quarterly ratings performance in the U.S. markets for many years. At $51.3 billion, the volume of debt downgraded was the lowest quarterly total since the third quarter of 1999 and was just one-fifth of the previous quarter's total. Such a substantial quarter-on-quarter drop is an extremely rare occurrence even when one considers ratings data for the last two decades. The resultant downgrade-to-upgrade ratios, 2.11 for the number of actions, was similarly at multi-year lows. With such a dramatic improvement in the downgrade tally since the first half of the year, 2003 is now on track to deliver a substantial improvement over last year. The 338 downgrades that were experienced in the first three quarters of this year affected $540 billion par value of debt. For the equivalent period in 2002, 455 downgrades affected $879 billion on the way to a full-year 2002 total of 652 downgrades on $1.3 trillion of debt.

On the upgrade front, the news was not quite so impressive but revealed positive trends nonetheless. This is to be expected as the early stages of a credit recovery are evidenced more by a lessening of downgrade pressure than a spate of upgrades. The 46 upgrades of third quarter this year maintained the year-to-date pace and affected $84.8 billion par value of debt. This brings the upgrade tally for the first three quarters of the year to $221 billion (143 upgrades), which already exceeds 2002's full-year total of $201 billion from 132 upgrades.

The improvement was really driven by the investment-grade credits where there was a dramatic fall in the volume of downgrades to just $16 billion which were offset by $62.6 billion of upgrades. However, the speculative grade arena also recorded a quarterly fall in the number of downgrades to just $35 billion confirming that the stabilization of credit quality is being experienced across the credit spectrum. Further, the fallen angel data continues to provide one of the more positive notes in the year's rating story. The third quarter recorded just 13 fallen angels and the $10.3 billion of their debt brought the year's tally to just $36.7 billion. By comparison full-year 2002 fallen angel debt totaled $201 billion. The number of rising stars remains very limited. There were just two in the latest quarter and they carried less than $2 billion par value worth of debt. In all of 2003 the par value of rising star debt has been just $10.8 billion, but even this is twice 2002's total of $5.5 billion.

The worrying part of the quarterly ratings report comes via the fact that the reviews data strikes a somewhat sour note. In the third quarter, 66 companies were placed on review for downgrade versus 60 in the previous quarter. And only 21 companies scored an upgrade review, down from 23 last quarter. The lack of improvement in this metric does raise concern that the sharp improvement in the ratings actions reported in the third quarter will prove to be somewhat of an aberration and that the degree of improvement will not be sustainable. This should not be unduly concerning as there is no denying that ratings are reflecting a general improvement in credit quality, but the moves in pricing have already been so substantial that investors are rightly looking for repeated confirmation of the value in current spread levels. We have expressed reservations about current spread levels for many reasons and the relationship between spread levels and ratings activity has never been strong, but if the current snapshot of rating reviews is indicating that the final quarter of the year will once again see a spate of downgrade activity then it is just one more reason to question the sustainability of an index Option Adjusted Spread level of 100 basis points or less.

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