Significant credit rating actions for Southern European sovereigns this week, including a downgrade to junk status for Greek debt, sent a wave of nervousness through the corporate credit markets. Corporate credit spreads widened across the board, although it was Southern European companies that were impacted the most. As uncertainty remains over the size of any support package for Greece, how this will be funded, and the knock-on effects for the other peripheral Euro areas, credit spreads are likely to remain volatile over the short-term. But we would encourage investors in the corporate credit markets not to get too caught up in the sell-off and to remain focused on underlying company fundamentals, as these remain distinctly positive. For a start, the Q110 reporting season is progressing extremely well. Not only have earnings from corporate credits generally surprised on the upside, but we have also seen a number of companies significantly boosting their profit guidance for the full year. And recent reports from the major rating agencies further underscore the improving trend in credit quality. Moody’s, S&P and Fitch have all highlighted that the negative bias on credit ratings that prevailed for most of 2009 has significantly eased in the first three months of this year.

A closer look at the latest ratings trends report from Fitch (titled “EMEA Corporate Portfolio: Spring 2010 Update”) reveals several interesting trends in this respect. Fitch confirms that the balance of outlook changes on credit ratings broke firmly into positive territory in January 2010, and that this trend continued through the first quarter of the year. Indeed, these changes led to the proportion of negative outlooks in Fitch’s total EMEA corporate portfolio falling from 35% at end-December 2009 to 25% at end-March 2010. There were 19 outlook changes from negative to stable by Fitch in Q110, including for UK retail bellwethers DSG International plc and Next plc. Most of these outlook changes were prompted by a rationalisation of costs, adequate liquidity, and better-than-expected profit for 2009. Admittedly, pure credit rating upgrades were limited over the quarter. This perhaps reflects the more cautious approach taken by the rating agencies in reversing the negative rating action bias, and the fact that it will take several quarters of further positive economic development to provide significant upgrade momentum. The exception to this was the Russian telco sector, where five companies were upgraded in the quarter by Fitch due to a better-than-expected performance over the last year.  The chart below shows how Fitch’s bias of rating activity has moved from more than 50% of negative rating actions in Q408 and Q109 to a more “normal” situation, where around 50-60% of actions were neutral by Q309, and a shift to a positive bias of actions to positive by Q110.

Fitch: quarterly distribution of rating actions

Source: Fitch

The outlook for Q210 remains positive. Fitch expects the favourable trend in outlook revisions (i.e. negative to stable, or stable to positive) to continue over the short-term, with the proportion of issuers with a negative outlook likely to move down from 25% to nearer historical norms. However, the outlook for rating upgrades remains modest. This is largely due to Fitch’s expectation of a slow and patchy recovery in EMEA, in line with our views. Indeed, we see recent improvements in fundamental corporate credit quality as merely cementing the position of many credits at their current rating levels and lessening the risk of rating downgrades, rather than providing significant momentum to upward rating actions. But Fitch goes on to outline several exceptions to the trend, in particular where recent performance warrants a block reassessment of a sector’s creditworthiness. Interestingly, the rating agency highlights both the automotive and media sectors as showing signs that could accelerate a stabilisation of these sectors. For the autos, Fitch notes that, although impacted by the recession, the sector has performed better than the harsh forecasts on which Fitch had based its ratings, suggesting that we could see positive credit rating outlook changes in this sector in near future. This view is supported by the strong Q110 earnings we have seen from many European auto names in recent weeks (for example, see our recent Daimler blog). Fitch also highlights that the media sector is recovering quicker than expected, benefiting from effective cost cutting measures, among others. The media and automotive sectors join chemicals, capital goods, and technology companies on the list of sectors that could see a change in outlook to stable from negative in Q210.

But while fundamental developments are improving, it is perhaps best not to get too carried away. Though credit ratings in many sectors are stabilising, this is often at rating levels well below those at the start of the downturn. And there remains the risk that the fragile economic recovery witnessed in recent quarters could be derailed should European bank balance sheets suffer significant losses from any restructuring of Greek and peripheral area debt, which could lead to another credit squeeze. But for now fundamentals in the European corporate credit market remain in good shape. Many companies have used the global financial crisis to streamline and deleverage their operations, leaving them in a solid position to weather further volatility and any economic decline. And credit ratings, currently, remain on an upward trajectory. Recent events surrounding Southern European credits have provided a degree of volatility in terms of credit spreads. But in our view, and in light of fundamental developments, this could present a buying opportunity of good quality corporate names. This is especially true for those credits in more defensive sectors, such as utilities, where a  further downturn in economic growth would have limited fundamental impact.

Nicola Sanders - Credit Analyst

Disclaimer:

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