Junk market seen in "very benign" default environment

By Paul Deckelman

New York, June 15 - The high-yield bond market is currently in what one expert characterized as a benign default environment - and that's not likely to change any time soon, in the view of participants at a high-yield bond conference held Wednesday in New York.

Default rates were, in turn, seen as a key determinant of what kind of rest of the year the high-yield market will have.

Besides terming the current environment "very benign," David T. Hamilton, the director of corporate default research at Moody's Investors Service, said that besides despite the recent downgrades of General Motors Corp. and Ford Motor Co. to junk or barely-not-junk status by the major ratings agencies and the resulting price movements, "high-yield credit quality remains stable."

Hamilton told attendees at the New York Society of Securities Analysts' 15th annual junk bond conference that in May the global speculative-rate default rate, measured on a 12-month trailing basis, fell to 1.9%, while the domestic default rate for below investment-grade bonds was 2.2%, both eight-year lows.

That surely is a turnaround from the historic high default rates of the recent past. Measured on a percentage-of-issuers basis, the global default rate hit a peak of 10.9% in January 2002, while on a percentage of total dollar issuance basis, it hit a zenith of 23.4% in November of that year.

Since then it has come steadily downward, with the two methods of default measurement having essentially converged in December 2003 and having moved in close tandem since then.

Last November, Moody's issued its projections for likely default rates this year, predicting that the global rate would bottom out around 1.9% in the early part of 2005, stay around 2% through midyear and then creep back up to 2.59% by November - actually above the 2.41% November '04 levels, but still very low by historical standards.

Cutting forecast

Hamilton said Wednesday that Moody's was now adjusting that forecast - given that there have been fewer defaults than the ratings agency expected. Its statistical model had indicated in the spring of 2004 that between the beginning of June last year and May 31 of this year, there would likely be around 40 global defaults - but only 29 actually occurred in that stretch, And in the first five months of this year, there have been only 11 issuers sliding into default on $2.9 billion total principal amount of bonds.

Because of the lower-than-expected amount of defaults, Hamilton said that the default rate "is not going anywhere" for now, and will likely remain in that same 1.9%-2.0% context for the remainder of the year, and probably won't start turning upward at least until the beginning of 2006.

"We expected to have seen that turn about now," he said, "but the lower number of defaults pushed that turning point off."

Upgrades match downgrades

"If we look at existing credit ratings, there are no warning signs of a spike [in default rates] any time soon," the Moody's analyst said. The ratio of ratings downgrades to upgrades - which shot up to better than 12:1 in the fall of 2001 - has been relatively flat the past 12 months, and now stands at 1:1 - one downgrade for each upgrade and vice versa.

At the same time, the ratio of issuers whose debt is put on watch for a possible downgrade at a later time to those put on watch for a possible upgrade has likewise remained steady, at about 1.5:1 since the 2003 fourth quarter, and, along with the ratio of positive outlooks to negative outlooks (which has fallen steadily since 2003, although a majority of existing outlooks remains positive), do not point to any sharp escalation in the default rates in the near to medium term, he noted.

"Absent a great macroeconomic shock," Hamilton continued, he does not think the credit markets will see a repeat of the volatile rates of the recent past.

Instead, the markets would see "a fairly moderate pace in the rise [of the number and dollar value of defaults] and a fairly moderate rise in the level."

Moody's now expects a default rate somewhere around 3% by July 2006 - around the middle point of a range that could go from just below 2% in a lower-stress best-case scenario, to just under 5% in a higher-stress situation. Even in that latter event, though, the default rate would stay at or below the 4.9% historical average, at least over the near term.

The largest component of the global default picture is U.S.-based companies, which accounted for fully eight of the 11 issuers who have slid into default globally this year, accounting for $2.4 billion of the $2.9 billion of defaulted bonds.

Besides geographic concentration, the defaults, not surprisingly, are concentrated at the lower end of the ratings scale. While the percentage of defaults among issuers in the Ba category (Ba1, Ba2, Ba3) was virtually nil both last year and so far this year, and stood at under 2% of issuers in the B category (B1, B2, B3), some 8% of the issuers whose ratings are Caa1 or below were in default so far this year - and 18% last year, when the overall average global speculative grade default rate was about 4%, double this year's rate.

That concentration of defaults among lower-rated issues could be the wild card that determines which of the scenarios outlined comes to pass.

Hamilton, as well as several other conference presenters, noted that during the record-breaking new-issuance binge of the past two years - which has continued in a somewhat modified form this year - the proportion of new deals rated Caa or below at the time of issuance is "unprecedented," with low-rated issuers of B3 and weaker accounting about one-third of all issuers bringing deals. That far outstrips the roughly 20% that did deals even at the height of the new-deal deluge of the late 90s.

Frankly, Moody's regards this large percentage of low-rated issuers to be "worrisome," carrying with it the potential for causing default rates to spike up somewhere down the line. However, Hamilton said it was "still not clear" what overall effect this would have, and said it would not impact the default rates on higher-rated issuers.

Low-rated deals seen aiding issuers

Peter Acciavatti, a managing director for JP Morgan Chase, told the conference-goers that while there had been "a pretty dramatic increase in lower-quality issuance," with 2003 and 2004 about matching the 1997-1998 levels of the dollar-value of the lower-rated new debt - $18 billion in 1997 and $31 billion in 1998, versus $15 billion in 2003 and $32 billion in 2004 - such a comparison could be misleading.

He pointed out that a significantly larger percentage of the issuance in 2003-2004 was for the purpose of refinancing existing debt, versus 1997-1998. With so much of the new debt coming from issuers who already had bonds out there, Acciavatti said, "seasoned issuers have a lower probability of default" than first-time borrowers.

More importantly, he said, "a lot of refinancing-oriented issuing meant that the issuers were able to extend maturities and improve their balance sheets without adding any net new debt," thus, if anything deferring near-term default risk.

Excluding the bonds sold to refinance debt, he continued, the amount of lower-rated debt issued in 2003-2004 "dropped substantially," to just $4.3 billion in 2003, $14.9 billion in 2004, and $5.1 billion so far this year.

Elaborating further, he noted that a lot of the debt issued in the late '90s was either lower-rated, non-refinancing debt, or was issued by wireline telecommunications companies to fund their network build-outs. Many of those telecom companies, armed with just a business plan and after racking up huge losses, later defaulted on their bonds or even went bankrupt and were ultimately liquidated.

In contrast, he said, "aggressive issuance" - which accounted for 5.7% of the market in 1998 - only accounted for 1.6% of 2004's year-end market size, and year-to-date accounts for only 0.5% of the current market.

"So this chart [of new-deal issuance over the past 2½ years] does not look quite as similar as the mid- and late-90s looked, and it doesn't look quite as troubling."

JP Morgan, Acciavatti said, expects the default rate to remain below 2% for the remainder of this year, and on into next year.

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