The Financial Times tells us that Standard & Poor’s forecasts that corporate defaults are due to rise thanks to tightening credit conditions. While S&P focused on 75 at-risk issuers with a total of $35 billion of debt outstanding, hardly an earth-shaking number, the report said more could be in store. Defaults on junk bonds could rise to the 2001-2002 level of 11%
Note that just last week, Moody’s also predicted a considerable rise in junk bond defaults, but did not offer a downside scenario as grim as S&P’s, which foresees the possibility of a “full blown debt crisis.”
One of the main contributing factors is a general deterioration in credit quality. A recent story in the Economist pointed out that observers had long expected a rise in corporate bond defaults and were perplexed that it had not yet happened. The article offered some explanations:
A recent paper by Edward Altman, a Stern School of Business professor who is the academic doyen of the bond markets, shows how remarkable this situation has been. The proportion of high-yield bonds that have been pretty junky, rated B-minus or below, has been high in recent years (see chart below). The most recent figure, for April, was nearly 50%. The worst of all ratings (except for those issues that are already in default) is CCC; this is the rating for around 20% of junk bonds and more than 50% of debt issued by this year’s leveraged buy-outs. Historically, more than half of CCC bonds default within six years.
So you would expect the default rate to be edging higher. There was a bit of a pick-up in 2005, when the likes of Delphi, a maker of car parts, went under. But the default rate in 2006 was just 0.5%, the lowest since 1981; Mr Altman says the rate so far this year has been just 0.2%. That compares with a weighted average between 1971 and 2005 of 4.2%.
What explains this discrepancy? One obvious answer is macroeconomic. The economic cycle has been much less volatile over the past decade, making life easier for the corporate sector. In addition, corporate profits have risen sharply as a proportion of GDP, perhaps because globalisation and technological change have improved the power of capital over labour. It has been much easier for companies to service their debt.
A second explanation is more technical. The rise of hedge funds and private equity has created an enormous demand for high-yielding debt. When companies get into trouble, they tend to be rescued before they default.
This influx of liquidity has led to another change in the structure of the debt market. Recovery rates, the amounts that investors get back in case of disaster, have increased. According to Mr Altman, in the 2001-02 period the recovery rate (as measured by bond prices at the time the default was announced) was just 25%; last year, the rate was 65%, while in the first quarter of this year, it was 81%.
This suggests that the credit cycle has lengthened and explains why those waiting for a turn have been disappointed….
Speaking at last week’s hedge-fund conference in Monaco, Sam DeRosa Forag of Ore Hill Partners said that the default rate would rise to 16-18% during the next downturn, not too far short of levels in the 1930s. Mr Altman is less extreme, although he is predicting a return to the long-term mean in defaults. What neither of them is predicting, unfortunately, is when the downturn will occur..
According to the Financial Times, S&P has a view as to the timing and seriousness of a rise in corporate defaults:
John Bilardello, S&P’s head of corporate ratings, said the level of defaults could turn out to be much higher if the economy and the debt markets were to worsen further in 2008.
He said this week’s 50 basis point cut in interest rates would help sentiment and economic activity but warned that there was a risk of a full-blown debt crisis like the one in 2001-02 when $250bn-worth of corporate bonds defaulted.
S&P’s prediction for a sharp rise in default rates from the historical lows touched in the recent past underlines the fragile conditions of large swathes of corporate America.
The bulk of new defaults is likely to be found among the hundreds of companies with weak financials that over the past few years took advantage of over-accommodating capital markets to load up their balance sheet with debt.
“These companies are highly reliant on financial market access to support operational cash needs, but the plentiful liquidity for high-yield borrowers is almost surely a thing of the past,” S&P said.
The problem has been compounded by a steady rise in the proportion of US companies with a junk bond rating – a result of the boom in high-yield bond issuance over the past few years.
Companies rated “B”, the most common junk bond category, or lower, by S&P now make up some 40 per cent of the US corporate universe outside the financial sector, up from 35 per cent a decade ago. These companies have an average debt to earnings before interest, tax, depreciation and amortisation (Ebitda) of about 6 – a historically high level that will stretch their ability to repay creditors in the coming months, according to S&P.
The credit rating agency pointed out that its figures were conservative because they did not include homebuilders – one of sectors that is most vulnerable to a financial crisis following the bursting of the US housing bubble….
Veteran investors such as the financier Wilbur Ross have long been predicting a rise in corporate bankruptcies