Why Air Canada’s (TSX:AC) Credit-Rating Downgrade Is Bad for Shareholders

Air Canada (TSX:AC) has had its credit rating downgraded by Fitch. That’s bad news for shareholders.

| More on:
Economic Turbulence

Image source: Getty Images

Recently, the credit rating agency Fitch downgraded Air Canada’s (TSX:AC) issuer default rating to BB-. That’s a medium-low score on the rating scale, indicating an “elevated default risk.” While this isn’t the first time Air Canada has received a BB-, it’s the company’s first downgrade since the COVID-19 crisis began. The downgrade comes after Air Canada’s massive $1.6 billion financing package, consisting of both equity and debt.

It’s not always big news when a company sees its credit downgraded. Air Canada’s downgrade, however, comes during a period of close public scrutiny. The company is facing pressure from all sides, with government wanting more safety, shareholders wanting more flights, and passengers voicing various concerns depending on their perspective. As a result, AC’s downgrade has received a lot of attention and wide publicity.

What the downgrade means

When a rating agency downgrades a company’s debt, that can mean a number of different things. It depends heavily on what range the company’s credit rating was previously in and how much it was downgraded by. For example, a downgrade from AAA to AA just means a lower rating within a range of excellent ratings, while a downgrade from AAA to D means a dramatic fall off in a company’s credit worthiness to nearly guaranteed default.

Most credit downgrades are incremental, but occasionally you’ll see a company dramatically downgraded in one cut. For example, Occidental Petroleum was downgraded by three levels in March due to the oil price collapse at the time.

In Air Canada’s case, the downgrade was fairly incremental. The company had been sitting at BB before the update and was reduced to BB- afterward. That’s a decline of just one level. However, BB is already low (“non-investment grade”) on Fitch’s rating scale. A decline of just one more level would take Air Canada to B, which is very speculative and could make borrowing difficult.

Higher financing costs

At first glance, it might look like a bond rating cut isn’t a big deal for shareholders. Shareholders don’t hold a company’s bonds, so why worry about it?

The truth is that credit ratings are very much a concern for shareholders. A low credit rating is an indicator that a company’s finances are unstable, which is bad for shareholders and bondholders alike. More importantly, a credit downgrade can increase financing costs. When a company’s financial situation declines, bond investors demand higher yields, all else equal. Companies can’t easily get around this.

If Air Canada were to issue bonds at a low coupon rate, bond buyers would bid the offering down until the yield reached a level they considered appropriate. So, the company would ultimately incur the costs that the market demanded. This would make Air Canada’s financing costs higher than they would otherwise be, leaving less residual value for shareholders.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Button has no position in any of the stocks mentioned.

More on Coronavirus

Dad and son having fun outdoor. Healthy living concept
Dividend Stocks

1 Growth Stock Down 15.8% to Buy Right Now

A growth stock is well-positioned to resume its upward momentum in 2024 following its strong financial results and business momentum.

Read more »

Double exposure of a businessman and stairs - Business Success Concept
Stocks for Beginners

3 Things About Couche-Tard Stock Every Smart Investor Knows

Couche-tard stock (TSX:ATD) may be up 30% this year, but look at the leadership and history of the stock to…

Read more »

Plane on runway, aircraft
Coronavirus

Can Air Canada Double in 5 Years? Here’s What it Would Take

Air Canada (TSX:AC) stock has gone nowhere since 2020. Can this change?

Read more »

Senior housing
Stocks for Beginners

Home Improvement Stocks Are Set to Fall (When They Do, Buy These Like Crazy!)

Home improvement stocks are due to drop further in the coming months. But with solid underpinnings for the sector, it…

Read more »

An airplane on a runway
Coronavirus

Forget Boeing: Buy This Magnificent Airline Stock Instead

Boeing (NYSE:BA) stock is looking risky right now, but Air Canada (TSX:AC) stock? Much less so.

Read more »

Man considering whether to sell or buy
Stocks for Beginners

Goeasy Stock: Buy, Sell, or Hold?

When it comes to smart buys, goeasy stock (TSX:GSY) is up there as one of the smartest money can buy.…

Read more »

Woman has an idea
Stocks for Beginners

Here’s Why Magna International Is a No-Brainer Value Stock

Magna stock (TSX:MG) has been climbing back once more, but still offers huge value for long-term minded investors.

Read more »

Aircraft wing plane
Coronavirus

1 TSX Stock Down 60% That Could Bounce Back Stronger

Air Canada (TSX:AC) stock got severely beaten down in the March 2020 COVID crash. Here's why it's probably not going…

Read more »