Over the last five years, S&P Global Ratings’ Long-Term Foreign-Currency Issuer Credit Rating of a leading consumer electronics company deteriorated substantially, going from “A” (strong capacity to meet its financial commitments) in 2010 to “CCC+” (vulnerable) in 2015 (see Chart 1 below). Such dramatic changes in credit quality over a five-year period are more an exception than the norm.1 That said, factors such as technological innovation, changes in oil and commodity prices, geopolitical risks and sovereign debt defaults can lead to rapid and unanticipated changes in a company’s ability to service its debt payments.
Chart 1: Bond and Equity Prices for a Leading Consumer Electronics Company, July 2011 to June 2016
Is it possible to identify companies where credit quality is likely to improve or deteriorate significantly, even before the deterioration is fully reflected in security prices?Our empirical research shows that significant differences between credit risk priced by securities vs. fundamentals can flag changes in fundamental credit quality in advance. Specifically, when the implied scores (in lowercase) between S&P Global Market Intelligence’s equity market-based Probability of Default and CDS-based indicators are significantly worse (better) than S&P Global Ratings’, then there is a higher likelihood of reported credit fundamentals deteriorating (improving).
This was flagged in March 2012 (Point A in Chart 1 above) for the consumer electronics company in our case study. Equity prices (in purple) and bond prices (in light brown and dark brown) continued to fall. Despite subsequent news on the company’s strategy to restructure its operations, equity and bond prices have not recovered to the levels in March 2012.
We developed a process for credit surveillance using such market vs. fundamental indicators flags, plus credit risk related information and data, via a structured approach.
For more details, please refer to “Optimizing Credit Portfolio Surveillance: A Case Study” , August, 2016.
1 The Transitions Matrices Report from S&P Ratings CreditPro database shows that the historical average probability of an entity rated “A-” being downgraded to “CCC-“ or lower over five years was only 0.81%.