The amount of bonds that are eligible to be upgraded has dropped and will continue to do so for at least the next few months, according to a report by Standard & Poor's. The amount of bonds that possessed upgrade potential in September dropped to 318, down from August's 328, according to the report. Fewer upgrades may result in bonds remaining under CreditWatch or the downgrading of credits.
The main reason that fewer issued bonds are eligible for upgrades is that the factors that influence bond ratings have been falling for some time. Credit spreads will expand very slowly as risk is repriced by the market, therefore eliminating the possibility of a quick recovery for bond upgrade potential. "We think that the market is starting to reprice with spreads widening to around 370, especially for speculative grade credit," said Diane Vazza, head of global fixed income at S&P.
The rash of LBOs occurring lately have led to low-grade issuance flooding the market, as well as offering foreboding evidence to a wave of defaults that may hit the market by early 2006. "The speculative default rate is going to edge up slowly," said Vazza. "By the third quarter of 2006 we see the rate being at 2.8%. To put things in perspective, we see the average of the next four quarters at around 2.6%. The average of the last four quarters was 2.1%."
Recent M&A deals that have been financed by debt leads to additional pressure on the market as it is a complete divergence from the steady, safe balance sheet stance to which many in the market have grown accustomed.
Credits that will retain good potential for upgrades are those that are rated B+. Individual sectors with high upgrade potential include finance companies, insurance companies and banks, with an emphasis on European banks. Sectors that have the least upgrade potential include autos, healthcare and integrated oil and gas, among others. "We've definitely already hit our peak as far as this credit cycle goes. Although it may be healthy for the market, we will continue to see this slow erosion of credit," explained Vazza.