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The Great Upgrade: Corporate debt is being re-rated en masse

When pundits tried making sense of the global financial crisis back in 2008, credit ratings agencies were blamed for overstating the quality of corporate debt that ultimately defaulted. Now, having marked down debt as the pandemic wrecked economies, agencies are making one of the biggest upgrade-to-downgrade ratio shifts Europe's credit markets have ever seen.

In the first six months through June, there were 46 downgrades and 79 upgrades taken by Moody's and S&P, with the positive trend picking up momentum in the second quarter. In June, a mere six companies were rated downwards while 25 saw their rating improve.

This reversal signals the strength of the rebound on the continent. Not only are profits on the rise, making liabilities more serviceable, markets are awash with financing thanks to the most accommodative monetary policy in history. Abundant liquidity and low borrowing costs are a further benefit to corporates' ability to meet their debt obligations.

Risk-reward on a seesaw

What's good news for businesses is not necessarily good for investors. The past six months have seen a significant contraction in spreads across all classes of debt. Access to cheap capital is helping companies move from high yield to investment-grade. As more credits move up the spectrum, leaving few high yield options to meet investors' appetite, spreads could contract even further.

With the premium demanded for holding higher-risk debt falling, the risk-reward balance may be pushed off kilter. The next six months will show whether this trend has more headroom. Investors will be hoping that, this time around, the ratings agencies have got it right.