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March 31, 2020
Rating Agencies Action Summary
 

Market Pulse

Rating Agencies Action Summary

Rating Agencies Action Summary

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March 31, 2020

 
 

Amid the COVID-19 crisis, companies across the world have been affected as supply chains have been disrupted, commodity prices have fallen and people stay at home to limit the spread of the virus. In our view, the rating agencies have been and will continue to be very aggressive with downgrades during this economic cycle.

In previous cycles, rating agencies commonly “looked through the cycle” when rating companies. However, based on recent conversations and interactions with the rating agency analysts, we believe the rating agencies will now take negative actions when they first see evidence of weakness.

Rating agencies have reacted already as a number of sectors that are highly exposed have seen immediate downgrades. Furthermore, we would expect that other sectors could see wholesale downgrades in the future should the length and severity of the decline be longer than currently anticipated. Finally, there are certain sectors that should remain resilient and may actually benefit from the changes in consumer behaviour. We would not expect far-reaching downgrades in these sectors.  Below, we provide a summary of those sectors we see as falling into these High, Medium and Lower-Risk categories. For those interested in deeper analysis, we provide a sector by sector view provided by our analysts across the world.

As a baseline, the rating agencies are generally expecting a very weak first half of 2020 followed by a slow rebound in the second half of 2020. Overall, global GDP growth is expected to be flat (+/- 1%) in 2020 followed by low-single digit growth in 2021 and 2022

Please note that our global credit research team completed this analysis on or around March 31, 2020. As information and events around the world change, our views and analysis will evolve.

High-Risk Categories

The rating agencies have moved quickly to identify and downgrade certain sectors that have been immediately affected by the COVID-19 crisis. For the sectors noted below, the agencies have taken negative ratings actions across the board. Depending on length and severity of the decline, we could see further actions in these subsectors in the future. The Energy sector is facing heightened risk of downgrades as E&P, Midstream, Refiners and Oil Field Servicers have been decimated by a sharp drop in oil prices. Oil has gone from over $60 at the beginning of 2020 to just over $20 today, driving many of these companies into distressed territory. Another commodity-driven sector, Metals & Mining, has been hurt by lower commodity prices across all substrates (copper, iron and gold). Gaming, Lodging, Leisure & Entertainment are sectors that rely on the strength and spending of the consumer and these sectors have seen sharp declines in revenues as discretionary spending and travel has stopped almost instantaneously. Airlines, Aerospace and Infrastructure (Airports, Rail) have been especially vulnerable to this lack of leisure travel as well as the lack of business travellers. Autos, including manufacturers and part suppliers, have been hurt by supply chain disruptions and lower demand, which has forced plant closures.  Retailers and certain Restaurants (typically high-yield) have seen significantly lower demand as people delay discretionary purchases and stay at home. 

Medium-Risk Categories

In general, we would characterize the “Medium-Risk” sectors as “GDP-like” sectors that could see weakness in-line with the economic downturn as opposed to companies noted in the “High-Risk” category, which have seen an almost immediate cessation of revenues and cash flow. While we do not expect to see wholesale changes to ratings in these Medium-Risk sectors, we would expect weaker positioned companies to be downgraded or placed on negative outlook in the near-term. This includes Media, specifically advertising which is often one of the first costs cut by companies as demand wanes. Chemicals also fall into this category, as chemical companies will see lower profits due to lower demand given the weaker macroeconomic backdrop. Global Banks will also be impacted by the weaker macroeconomic backdrop, however the increased regulations since the Global Financial Crisis has led to high capital levels, extremely strong asset quality and ample liquidity, which should allow banks to absorb losses more easily. Insurance companies may be hurt by falling equity markets (Life) and potential payouts (P&C) While Industrials & Manufacturing companies will be impacted by poor end market demand and some supply chain disruptions, companies with diversified product offerings, end markets and geographies should fare well. Homebuilders & Building Products still have a strong fundamental backdrop as rates remain low and supply is tight but orders may decline and constructions projects will be put on hold. REITs are highly dependent on their end markets; those exposed to hotels, skilled nursing/senior housing and retail are more at risk as rental revenues may be in question.

Lower-Risk Categories

Several sectors should remain resilient in the face of COVID-19 and may actually benefit from increased demand. For these sectors, we do not expect more than a handful of downgrades. Utilities are likely to be the most defensive sector in the coming months given their regulated nature and hedged contracts. Non-cyclical consumer credits, primarily Consumer Products, should benefit from stable demand in their end markets. Packaging companies (typically high-yield) continue to benefit from their end market exposures to the food & beverage sectors. Credits within Technology may benefit as work from home requirements are driving demand in various technology subsectors. There is upside to hardware and component demand driven by equipment needs, increased software demand for virtualization, end-point security, recovery and backups, and cloud access. Telecom and Cable should see increased demand for both mobile and fixed connectivity, as more people work from home. Healthcare is a large and diverse sector. Facility-based healthcare providers may see increased utilization with coronavirus while smaller sub-sectors like healthcare equipment rentals and some pharmaceuticals should benefit from increased demand as well. Critical retailers, such as Food and Drug Retailers have seen sales increase as more people cook meals at home.

HIGH-RISK CATEGORIES

Energy
We have seen already seen and expect more negative rating actions. While investment-grade independent oil producers are in a much better shape than the last downturn, in terms of having lower leverage, limited near-term maturities and much more capital disciplined management teams. The negative angle to the situation now versus past cycles (e.g., 2015/2016) is that equity valuations are very weak in the sector overall and there is limited support from equity investors, providing less of a cushion. Fallen angel risk is something to consider carefully in this environment, and we have already seen several large IG energy names have their ratings downgraded.

In our view, while High Yield E&P will likely see significant defaults in the coming months and recoveries will be low, there will be survivors in High Yield Energy. We believe that many of the higher quality  companies in the Permian basin have the financial means to ride out this downturn. We would also not be surprised to see hastily arranged mergers be announced over the coming days and weeks. This could cause some relief, especially if larger Investment Grade companies merge with High Yield companies.

Metals & Mining
Mining across all substrates (copper, iron, gold) all sold off this month on coronavirus concerns. Weakness in China demand has contributed to lower copper and iron prices while gold, traditionally a safe-haven commodity, has acted as a funding currency for redemptions. We do believe investment-grade gold credits will be spared from rating downgrades due to significantly less leverage, strong balance sheets and gold prices still significantly higher than underlying cash costs.

As a result of weaker pricing over the last month, rating agencies have downgraded several names on the sector. Going forward, rating agencies will look at several indicators for potential downgrades: commodity pricing (especially steel) as well as companies reducing manufacturing capacity to preserve FCF.  

Gaming, Lodging, Leisure & Entertainment
The rating agencies have already downgraded a large number of companies across these sectors, reflecting the unprecedented decline in revenue and resulting impact on earnings, cash flow, and leverage expected from various travel restrictions and stay-at-home ordinances issued globally. Gaming operators will see revenue fall to zero as a result of temporary casino closures, as will various out of home leisure companies (cruise lines, gyms, among others), while hotel operators will experience a dramatic decline in occupancy. Although most companies across the space have adequate near-term liquidity to weather a short-term revenue disruption, further downgrades as well as potential defaults are likely if the duration of restrictions on travel and consumer activity is extended and/or the pace of economic recovery is slower than expected.

Airlines and Infrastructure
The rating agencies have downgraded the airline operators across the world, as this sector in particular has seen significant impact from decreased travel. Major airlines have already announced capacity reduction and bookings have fallen notably. Rating agencies remain cautious of the industry outlook and ratings are under review for further downgrades as agencies continue to assess further impact from the virus. Airline operators are focusing on short-term liquidity and have drawn  down on  their revolvers and secured additional liquidity from syndicate banks. The U.S. government has passed a +$50bn financial aid program to help the industry’s liquidity in form of grants and low-interest rate loans, however, the duration of the virus and timing of rebound in travel demand remains as the key factor for airline industry.

Airports are likely to be significantly impacted by the drop in passenger numbers. Rating agencies have taken negative action on airports, for the most part downgrading by one notch and keeping the outlook on negative. Whether we see further negative action will depend on how long this crisis lasts. If air travel continues to remain subdued for more than 3-4 months, we are likely to see further negative rating actions.

Rating agencies view the aircraft lessors faring better than airlines in this environment and we have not seen outright downgrades other than outlook changes to date. With this said, we expect rating agencies to start downgrading the aircraft lessors broadly given increasing deferred lease payments and increasing likelihood of payment defaults from low-tier airline operators pressuring the credit metrics.

Autos
To date, we have seen downgrades across the world for both auto manufacturers  and suppliers. In many cases, companies have been downgraded and remain on review for further downgrades.  Autos are being negatively affected by the coronavirus on both supply and demand side of the global auto industry. On the demand side, auto sales have been falling rapidly in recent weeks across all regions, which could deteriorate further with broader economic volatility. When the pandemic was mainly limited to China, OEM production and supply chains were impacted by production downtime. More recently, in response to fading demand, the large majority of global auto manufacturers have announced production shutdowns at most of their plants in Europe and in the U.S., and have switched to liquidity protection mode.

Retail
The rating agencies have already downgraded a number of retailers (non-food) on the back of store closures and have kept the ratings under review for further downgrade to reflect the uncertainty about the duration of the disruption and the effectiveness of announced cost cutting efforts and government support schemes.

Restaurants
The rating agencies have already taken actions across the industry given lower customer demand, but these have actions have been bifurcated between casual dining restaurants (CDR) and quick service restaurants(QSR). CDRs have seen a number of downgrades, while rating actions at QSRs have largely been limited to Negative outlooks thus far. In general, QSRs should feel less of an earnings impact from the coronavirus given a large portion (generally ~70%) of sales at these chains is already generated “off-premise” (e.g. drive-thru) and the larger restaurant brands tend to be highly franchised. CDRs largely operate “dine-in” models, and therefore are seeing a much greater drop in sales. We expect these trends to continue.

MODERATE-RISK CATEGORIES

Media
Many media companies depend on advertising as their primary revenue source and advertising spending is highly-dependent on economic conditions. We have seen advertisers already pulling back and focusing their spending on digital and television. It is too early to assess how long demand for advertising will wane – ad cycles are very short and can snap back quickly should consumers increase spending. However, a prolonged decrease in advertising spending could lead to downgrades. 

Chemicals
Given increased market volatility, the Chemicals sector continues to be negatively impacted – primarily driven by concerns of lower end market demand due to an economic slowdown especially China, which still represents a significant demand driver. These negative data points resulted in ratings downgrades on several names in the sector as earnings guidance continues to be reduced and / or eliminated. Going forward, rating agencies will closely be examining earnings, and assessing how pricing has been impacted by weaker demand, and the ability for companies to effectively manage both margin pressures and the likely potential of increased leverage. While all sub-sectors within chemicals will be negatively impacted from the sudden drop in demand and earnings pressure, specialty chemicals should fair slightly better with the benefit of lower raw material costs.

Global Banks
There have been limited rating actions for the banks and to date, though we have seen some broader outlook changes to negative in Europe. We expect downgrades as less likely compared to other sectors in the short-term given the solid fundamental position of the sector and the various support and forbearance measures. However, if the length of the crisis extends with more lasting damage on the real economy, we are likely to start seeing rating actions on the banks as well.

Insurance
There have been limited rating actions thus far for the insurance sector (Life and P&C). Life insurance companies had already been under pressure due to sustained low rates and declining equity markets, which have reduced the sector’s credit quality. These have been offset by the strength of the companies’ solvency ratios.  To the extent that we have a protracted recession or a tangible increase in defaults, we may begin to see life insurer capitalization metrics weaken, and ratings agencies begin to downgrade. Separately, rating agencies could make wholesale downgrades to P&C companies that are forced to take an unexpectedly large burden for business interruption claims. P&C names that focus on personal lines, rather than commercial, will be more insulated from potential ratings actions.

Diversified Industrials & Manufacturing
To date, we have not seen broad downgrades across the industrials sector. Many of these companies are  industrials that remain highly dependent on the macroeconomic back drop which will decrease end market demand across a variety of sectors.  However, diversified product offerings, ends markets and geographies should help limit the losses for these companies.  Less diversified, single end-market companies may see more downward pressure on ratings.

Homebuilders and Building Products
To date, we have not seen broad downgrades across the homebuilding/building products sector. The agencies have revised sector outlooks to reflect a more cautious view for the sector as homebuyer traffic and orders decline and construction projects are increasingly put on hold. However, generally conservative homebuilder balance sheets and a fundamentally healthy housing backdrop (tight housing supply, low rates, and favourable demographics) should allow the industry to better weather this downturn. We would expect sector-wide downgrades to accelerate if 2H20 economic recovery does not materialize.

REITs
Companies exposed to hotels, co-working space, skilled nursing/senior housing and retail are most at risk of downgrades given the highest risk of loss in rental revenues in the short to medium term. This is followed by office, mainly for operators with assets in secondary locations with weaker tenants than those who own properties in more desirable central business districts.

LOWER-RISK CATEGORIES

Utilities
We do not expect to see significant negative rating actions across this sector as utilities are viewed as more defensive. This is driven primarily by effective short-term hedging, but also because power demand continues to remain relatively consistent throughout periods of economic contraction. The majority of the sector is also comprised of diverse, regulated utilities with contracted rate bases, which provide stability. Power prices will remain weak over the near term as gas prices continue to remain low, but earnings / capital structures should remain less impacted given increased business diversification, reduction in capex spend as asset profiles continue to transition towards gas and away from coal, and management teams continue to push de-leveraging as an active part of their capital allocation strategy. Additionally, seasonality should provide an earnings uplift as the summer months approach, and power producers benefit from increased energy consumption.

Consumer Products
While many consumer companies have already profit-warned and pulled guidance for the year, the rating agencies have indicated that the outlook for consumer goods remains overall stable. Rating agencies have stated that lower operating profit growth in 1H20, potential supply chain disruptions and weak economic growth will have different impacts on the industry subsectors. For example, alcoholic beverages manufacturers with significant exposure to the restaurant, bar and travel segment will likely face an increased risk of downgrades compared to traditional consumer products companies that provide packaged goods that are consumed at home.

Packaging
Even with increased macro headwinds, packaging continues to benefit from the sector's more defensive food and beverage end-market exposure. Commentary from management teams highlighted that social distancing has reduced demand for beverage can / glass products (beer / liquor), but that overall volumes have remained relatively constant due to increased usage of plastic and paper bag use from grocery / convenience stores. As a result, these companies have exhibited stable free cash flow characteristics and improved leverage metrics, as well as solid liquidity profiles. Rating agencies have so far echoed this business stability, and there have been no wholesale downgrades.

Technology
We have not seen substantial negative rating actions in the technology sector and overall; we believe that the tech sector is better insulated than many other sectors from downgrades. Larger technology companies are more insulated from COVID-19 given their balance sheet strength and portfolio diversification. In particular, the software and services industry should remain resilient, primarily driven by recurring revenue and enterprise demand. Hardware and semiconductors may see near-term risk from supply chain disruptions, which will likely be offset by higher demand for consumer PCs & components (created by working from home needs), networking, and cloud infrastructure/services.

Telecom and Cable
We believe these sectors will be insulated from rating actions because of their resilience amid the crisis. In fact, the sector could instead benefit from this environment, due to increased demand for both mobile and fixed connectivity, as more people work from home and stay home to avoid large public gatherings. While rating actions cannot be ruled out, we believe downgrades would be mostly driven by idiosyncratic stories rather than broader sector weakness.

Healthcare / Pharmaceuticals
Healthcare is very diverse sector that should see positive demand across its many subsectors.  However, there are pockets of weakness including companies that provide supplies and services for elective procedures that are being deferred. While government and private payers will cover most COVID-19 cases through current payment schemes and stimulus package, financial stress could come from prolonged periods of lower profitability and margin erosion.

Food and Drug Retailers
Food and drug retailers have seen demand levels for their services soar as these retailers have been deemed “critical” by governments across the world and are mandated to remain open.  As a result, these companies should see higher profits and better levels of liquidity compared to other retailers. We expect these trends to continue.
 

RISK CONSIDERATIONS

There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and that the value of Portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower rated securities. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Distressed and defaulted securities are speculative and involve substantial risks in addition to the risks of investing in junk bonds. The Portfolio will generally not receive interest payments on the distressed securities and the principal may also be at risk. These securities may present a substantial risk of default or may be in default at the time of investment, requiring the portfolio to incur additional costs. Preferred securities are subject to interest rate risk and generally decreases in value if interest rates rise and increase in value if interest rates fall. Mezzanine investments are subordinated debt securities, thus they carry the risk that the issuer will not be able to meet its obligations and they may lose value. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. In general, equity securities' values also fluctuate in response to activities specific to a company. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).

 
 
 
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