CreditSights: Downgrades Outpace Upgrades
The latest aggregate ratings data from Moody's Investors Service showed a slight loss of traction in the month of May. The number of downgrades increased slightly--30 during the month versus 26 in April--and the number of upgrades fell to 22 from 28. This ends the three-month streak in which we had experienced a consistent drop in the number of downgrades and increase in the number of upgrades. In our view, the "slippage" in the numbers does not signify a reversal of the recent improvement in credit quality but are merely backing and filling in the ongoing trend. This is to be expected, particularly with regards to the number of monthly downgrades, which have already fallen substantially. In the first five months of 2004 Moody's has downgraded 147 companies. Over the same period in 2003, this fate had befallen 202 companies.
But this time period is really too brief to give us much insight into the way in which this upswing in the credit cycle is playing out and the degree of further improvement in the ratings statistics that we can reasonably expect. To add a greater depth of perspective, we review the monthly average of downgrades calculated over the last 12 months. It currently sits at 34 downgrades a month versus the May 2003 level of 47 downgrades a month, indicating that substantial gains have been made on the credit quality front.
If one looks at this measure historically, the absolute numbers suggest that there are still further gains to be made here. As the credit markets recovered from the recession of the early 1990s, the average number of monthly downgrades fell below 20, a level that it was able to sustain right up until the second half of 1998. By that measure, the current pace of downgrades still seems high but by just looking at absolute numbers, we are ignoring the growth in the market that has occurred in the intervening years. The market valuation of the Lehman Credit Index was $1.2 trillion at the end of 1998. It was $2.2 trillion by the end of 2003. Given the explosion in the amount of corporate debt--and by inference, the number of corporate debtors--comparing absolute numbers of ratings actions with previous periods provides only a partial reference point.
By plotting the average monthly number of downgrades against another credit quality measure that captures this market growth, such as the percentage-based speculative grade default rate, a better picture of the cycle emerges and it is one that suggests there is further upside in the credit cycle. Moody's is predicting a further drop in the default rate to 2.8% by year-end 2004 and it would be consistent to see the average number of monthly downgrades move into the 25-30 range by that time. We would not expect the number of downgrades to fall much below that however.
When the current volume of downgrades is viewed as a percentage of the credit index capitalization, we are already at levels that equal the best performance at the peak of the last credit upswing, suggesting further improvements in this measure will be hard won. However, we should see further increases in the monthly number of upgrades. This is a statistic that, to date, has been lagging the other readings of credit quality. In 1997, this measure peaked at 25 upgrades a month. The latest measure is just 19 a month, despite the growth in the market in the last seven years. The recent volume of upgrades expressed on a percentage basis relative to the index is still less than one third the levels it reached at its last peak, all of which indicates that this measure should rise appreciably in coming months as the credit cycle matures.