By the standard of recent years, 2013 was a calm one in the European corporate credit arena. The first half saw the eurozone still in recession, although this was offset by a 0.3 percent increase in GDP in the second half. Meanwhile, only four long term sovereign debt ratings were downgraded, down from nine in 2012.
Indeed, on an international level, the credit quality and stability of corporates improved in 2013. The ratio of downgrades to upgrades decreased relative to 2012 and, by the end of December 2013, the global speculative-grade default rate had fallen to 2.23 percent from 2.52 at the end of 2012.
Despite this increased stability, however, the percentage of defaulters from Europe hit an all-time high with nearly 20 percent of the total global default count in 2013. Indeed while other major regions’ proportions of the total were roughly in line with 2012 levels, Europe saw 16 defaults in 2013 – an increase of nearly 80 percent from 2012, when nine corporates defaulted.
At S&P, we believe that the eurozone sovereign debt crisis, starting in 2009, played a crucial role in the faltering creditworthiness of European corporates – especially for those in the financial sector – and continues to have an impact.
Europe’s performance against international regions
For the most part, major regions saw declines in their annual speculative-grade default rates in 2013. Europe, however, was the exception. In the full year, 81 speculative grade global corporate issuers defaulted, relatively unchanged from 83 in 2012. Regionally, the default rate dropped to 2.12 percent in the U.S. and 1.96 percent in the emerging markets from 2.58 percent – against 3.33 percent in Europe, up from 2.2 percent a year earlier. Indeed, in the fourth quarter of 2013, the majority of defaults internationally stemmed from Europe.
So, while the overall global default rate fell, Europe’s default rate increased – a performance that reflects our view that there remains continued challenges in some parts of the region despite improvements in overall economic stability.
We believe that the eurozone sovereign debt crisis, starting in 2009, played a crucial role in the faltering creditworthiness of European corporates
The euro sovereign debt crisis
Despite the decline in sovereign downgrades, ripples from sovereign debt crisis remained apparent in 2013. Peripheral European countries again provided the region with most of its drama in 2013, notably Cyprus. The nation’s banking sector was eight times the size of the overall economy when it began running into financial troubles. After initial refusal, the Cypriot parliament accepted a bailout package provided by the Eurogroup, the EC, the ECB, and the IMF. The €10bn deal came in return for the country agreeing to close the second-largest bank, Cyprus Popular Bank.
Certainly, the sovereign debt crisis has had a significant impact – not least because it led to a depreciation of the euro. This had a direct influence on corporates’ ability to pay their debts, furthering our view that the prevailing sovereign debt crisis has contributed to the downward trend for corporate creditworthiness.
That said, the ECB and euro area governments moved decisively to support the single currency in 2012 – saving Europe’s economy from depression. This had a beneficial impact on corporates, helping staunch further downgrade activity in the Eurozone. Certainly, the downgrade-to-upgrade ratio across all European companies was 1.47 percent last year, which is markedly lower than the 3.25 percent ratio in 2012.
Europe is still a work in progress
Yet it is not all bad news. Despite the sharp hike in defaults, overall stability among European corporates became more apparent in 2013. The percentage of unchanged ratings increased to 72.04 percent, which is a notable improvement from 62.08 percent in 2012, and demonstrates that creditworthiness is rebalancing throughout the Eurozone. Also, the volume of debt affected by defaults has decreased. In 2013 it totalled $17.8bn, down from $19.7bn in 2012 – a considerable improvement from the $38.7bn in 2009.
What’s more, Europe’s non-financial sector experienced an impressive percentage of upgrades. The number of upgrades in the non-financial sector outstripped those in the financial sector, and the rising stars of the year – corporate entities who we have upgraded to investment grade from speculative grade – were all non-financial companies.
The inherent volatility of the financial sector
Conversely, the financial sector underperformed in 2013. We saw eight fallen angels, which are entities downgraded to speculative grade, four of which were financial institutions. Generally speaking, financial institutions are sensitive to sudden declines in investor confidence, which can result in a relatively fast descent into default – something particularly apparent since the financial crisis.
Credit ratings and their continuing significance
To date, S&P default studies have found a clear correlation between ratings and defaults: the higher the rating, the lower the observed frequency of default, and vice versa. Over each timespan, lower ratings correspond to higher default rates, which means that the ability of corporate ratings to serve as an effective measure of relative risk remains intact.
Furthermore, transition studies have repeatedly confirmed that higher ratings tend to be more stable and that speculative-grade ratings generally experience more volatility.
S&P’s ratings analytical methodology divides the task into several factors – first, analysts examine a company’s business risk profile, then its financial risk profile before combining those to determine an issuer’s so-called ‘anchor’.
To determine the assessment for a corporate issuer’s business risk profile, the criteria combine our assessments of industry risk, country risk, and competitive position. Cash flow/leverage analysis determines a company’s financial risk profile assessment.
The analysis then combines the corporate issuer’s business risk profile assessment and its financial risk profile assessment to determine its anchor. In general, the analysis weighs the business risk profile more heavily for investment-grade anchors, while the financial risk profile carries more weight for speculative-grade anchors.
After determining the preliminary anchor, analysts consider additional factors to modify it. These factors are: diversification/portfolio effect, capital structure, financial policy, liquidity, and management and governance. The assessment of each factor can raise or lower the anchor by one or more notches – or have no effect.
After that, comparable ratings analysis is the last analytical factor used to determine the final Stand-Alone Credit Profile (SACP) on a company. The SACP is then considered alongside any relevant external support – e.g. from the public sector – to determine the final Issuer Credit Rating. The full corporate ratings criteria are available here.
Corporate ratings depend on stabilisation
In conclusion, despite measures to strengthen monetary union and the region finally emerging from recession, it is clear Europe’s corporates continued to face downward pressure in 2013.
The performance of Europe’s corporate default and transitions against its international counterparts certainly demonstrates the continent’s stunted growth. In our view, it is clear that the subsequent downgrading of Europe’s sovereigns in 2013 reflects the continued challenges in some parts of the region. And despite improvements in overall economic stability, the success of its corporates – particularly in the financial sector – is closely correlated with the recovery from the sovereign debt crisis.