September 2024 Edition

Welcome to Global Credit Insights. Every month, we bring you the top research insights from Morningstar DBRS, the leading provider of credit ratings and thought leadership on corporate and sovereign entities, financial institutions, and project and structured finance transactions.

Rating more than 4,000 issuers and 60,000 securities, Morningstar DBRS is one of the top four credit rating agencies in the world. To learn more, visit dbrs.morningstar.com.

Rising Challenges for Airlines—Low-Cost Carriers in a Pickle

Many airlines in North America and Europe are struggling to keep up with strong financial performances posted in 2023; low-cost carriers (LCCs) in general are feeling more pressure than full-service carriers (FSCs). We expect LCCs to continue to face a challenging environment in the near term due to softening consumer spending, which is likely to keep passenger yields and margins under pressure.

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Morningstar DBRS Credit Estimate Snapshot: Q2 2024 Financial Metrics Deteriorate Modestly

• The Credit Estimate volume is down from Q1 2024 but on par with Q2 2023, mainly driven by a slowdown in new middle market loans production earlier this year.
• In Q2 2024, we issued 65 CEs for new borrowers, down from 92 in the first quarter this year.
• In Q2 2024, the overall credit quality of new borrowers is slightly better relative to the refreshed borrowers.
• Approximately 77% of 27 upgrades occurred on lower quality borrowers, including B (low) and CCC (high) mainly driven by lower leverage and partly by higher revenue and proforma net income.
• In this quarter, higher leverage and lower interest coverage were seen across all sectors, and consumer cyclical sector had the biggest decline in Revenue Growth with other sectors remain stable.

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Japanese Banks: Impact of Extreme Volatility

• Nikkei 225 stock index fell more than 12% on August 5th, but recovered 10% the next day
• The yen weakened by more than 2% on August 7th after the Bank of Japan said it would not raise rates as long as markets are unstable

Overall, we consider the banks' financial fundamentals to be solid, with earnings improving in recent years mainly thanks to a more favorable interest rate environment. The banks hold significant cross-shareholdings through Japanese equities and Japanese government bonds; however, they have been actively unwinding these securities holdings in recent years. Capital buffers over the regulatory minimum were ample at end-F2023. Meanwhile, the banks' CET1 ratios are likely to continue to benefit from their improved capacity to generate earnings, providing room to absorb shocks.

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Large U.S. Banking Companies Readily Meet Capital Requirements Following Finalized Stress Capital Buffers

The Federal Reserve Board has announced the large banks' capital requirements incorporating the now finalized Stress Capital Buffers. These requirements are largely in line with the preliminary SCBs.

• As of June 30, 2024, banks already met the new requirements. We note that SCBs for the G-SIBs, which have an additional buffer and include additional other comprehensive income in their CET1 calculations, are tighter to requirements.
• Regional banks have been building their CET1 in anticipation of higher regulatory capital levels, including the likely inclusion of additional other comprehensive income in their regulatory capital calculation.
• Many banks have resumed capital management activity, including stock buybacks, albeit at a more measured pace than in previous years.

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Volatility in Global Stock Markets Raises Questions Around Soft Economic Landing; Limited Impact on Corporate Ratings Outlook

Last month’s weaker-than-expected U.S. jobs report sparked fears about a slowing U.S. economy and resulted in an equities sell-off across the world’s major stock markets.

• However, we view the direct credit impact on the credit ratings of corporate issuers in our global coverage portfolio to be relatively limited.
• We anticipate negative effects to be more meaningful only for relatively smaller, non-investment-grade companies with already strained credit metrics.
• Investment-grade corporate issuers that have adequate capital and liquidity cushions, as well as robust geographic diversification and economies of scale, are usually equipped to withstand weaker trading environments.
• Corporate issuers operating in more stable sectors are better positioned to withstand such headwinds compared to those in discretionary or cyclical sectors.

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Q2 2024 Private Rating Actions Highlight Bifurcation Between Higher- and Lower-Risk Issuers

Downgrades continued to exceed upgrades during Q2 2024 among the private credit issuers we rate. There is a growing bifurcation between the highest-risk credits and a subgroup of issuers where operating pressure has begun to recede.

• The group of highest-risk issuers (rated CCC or lower) increased during Q2 2024 to 7.6% of the portfolio from 6.0% at year-end 2023. Defaulted issuers rose moderately to 0.8% of total rated issuers at mid-year from 0.6% at the end of 2023.
• For the most recent quarter, the ratio of private credit downgrades relative to upgrades measured 2.5x, in line with Q1 2024 at 2.6x.
• We generally expect downside risks to exceed upside potential for middle-market issuers. As credit quality improves, the impact on the rating can often be overshadowed by an increase in debt-funded growth or sponsor dividend payments.

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Approach to Data Set

The figures above are based on data from Morningstar DBRS’s proprietary database (ratings from January 1, 2023 to August 31, 2024). The data set includes public and private ratings in all sectors. Morningstar DBRS tabulated confirmations, upgrades, and downgrades at the issuer level; as such, where there are multiple debt security ratings, Morningstar DBRS only used the issuer rating or its proxy for corporates, sovereigns, and FIG sectors, and only used the trust rating for its proxy for structured finance. Morningstar DBRS did not include under review or trend change rating actions in the tables.

Rating actions were counted by aggregating ratings across company IDs and taking the mode of the rating action. As such, in some cases ratings activity may be overstated. For example, Credit Suisse Group AG and Credit Suisse Group Finance (U.S.), Inc. will have two unique company IDs and will thus yield two different ratings counts in our data despite being from the same company.

Morningstar DBRS aims to remove the impact of overstating rating activity by issuing subsidiaries and affiliates (together, related entities) on the data set in cases where there is a direct relationship to the parent company’s rating. The objective of this adjustment is to eliminate the impact of migrating a series of ratings that ultimately rely on one entity. Please note that this approach is specific for the purpose of this newsletter, and may not be consistent with other rating activity summaries produced by Morningstar DBRS for other purposes (such as the transition study data tabulated for the NRSRO).