Capital Markets

Angels Flying Too Close to the Ground

Fewer companies were downgraded to junk last year than in 2006, but these 'fallen angels' are coming down to earth faster and harder.
Stephen TaubJanuary 14, 2008

Ratings on 42 companies worldwide were downgraded to junk in 2007. That’s fewer than the 47 so-called ‘fallen angels’ in 2006, says a new report from Standard & Poor’s says, but most other signs point to a continuing deterioration in credit quality.

Indeed, although five fewer companies lost their investment-grade status last year, the volume of debt affected by these fallen angels nearly doubled, to $131.3 billion at the end of 2007 versus $70.2 billion in 2006.

In addition, for the second straight year, the number of fallen angels outpaced rising stars. S&P blames this trend on the U.S., where in 2007, there were 33 fallen angels versus 14 rising stars. In other countries, the pattern is reversed, with only nine fallen angels and 22 rising stars.

The number of fallen-angels per year peaked in 2002, when 130 companies lost their investment grade status — a number representing 4.07 percent of the 3,196 investment-grade issuers. The previous peak was in 1986, when 52 fallen angels represented 3.92 percent of investment-grade issuers.

“Over the long term, fallen-angel incidence mirrors the broader movement in credit quality (as measured by the ratio of downgrades to total rating actions), with the correspondence of the peaks and troughs between these two trends,” S&P noted in its report.

In general, the number of fallen angels generally increases during periods of weak real GDP growth and declines when GDP is strong. “This inverse correlation is not surprising, because corporations’ aggressive leverage at the peak of the economic cycle makes them vulnerable to potential credit downgrades when economic conditions deteriorate, resulting in an increase of fallen angels during troughs in the economic cycle,” S&P explained.

The rating agency also pointed out that deregulation or technological changes can cause companies in certain industries to be downgraded to junk.

No surprise, it was the homebuilding and health care sectors that saw the largest number of wings clipped in 2007, with six fallen angels in each sector. The telecommunications industry led by debt volume, with three fallen angels accounting for $19.6 billion in downgraded debt.

S&P says a large number of companies in still in danger of being dropped from investment grade to speculative grade. The ratings agency says 40 companies accounting for a total of $56.6 billion in debt are listed as potential fallen angels as of January 7. (A potential fallen angel is defined as companies rated BBB- with either a negative outlook or on CreditWatch with negative implications.)

The most vulnerable sectors are forest products and building materials, followed by the already stumbling homebuilding and real estate companies.

By debt volume, the leading contenders to produce additional fallen angels include the homebuilding and real estate sectors, forest products and building materials, media and entertainment, and the utility sector. The biggest potential candidate: General Growth Properties Inc., a real estate investment trust with more than $4 billion in rated debt.