Enron to have no impact on spec-grade default rate, Merrill's Fridson says

By Paul Deckleman

New York, Dec. 5 - The quick slide which Enron Corp. debt took - going from a nominally investment grade-rated credit to a defaulted company in Chapter 11, all within a matter of days in late November and early December - "was largely a non-event for mainstream high yield investors," declared the chief high yield strategist for Merrill Lynch & Co., Martin S. Fridson.

"They were under no obligation to take the rapidly deteriorating company's bonds off the hands of the unfortunate investment grade holders" who had bought the debt back when it was still a high-grade credit, Fridson said in a new research note.

"Accordingly, a default rate influenced by Enron's sudden demise would be irrelevant to mainstream high yield portfolio managers. To the extent that Enron paper left the high grade portfolios before defaulting, it mostly went into the hands of 'vulture capitalists,' i.e., specialists in bonds on the verge of, or already in default."

Indeed, Fridson noted, Enron's Dec. 2 bankruptcy filing will have "no impact" on the speculative-grade default rate compiled by Moody's Investors Service, which Merrill Lynch uses extensively in analyzing risk premiums related to high yield investment.

For one thing, he pointed out, the base for calculating the annual default rate consists of the debt of companies which were already rated lower than Baa3 at the beginning of the year, effectively excluding such "fallen angel" credits as Enron; the company was not downgraded to junk bond status by Moody's (as well as by Standard & Poor's) until Nov. 28.

While Moody's will include the Houston-based energy trading company's default in its 2001 default rate for all corporate bonds, as well as on its list of defaulting issues for December, "that list routinely includes issuers that do not figure in the agency's [high yield] default rate calculation for a variety of reasons," Fridson wrote.

It would be "fallacious to label Enron a speculative grade defaulter in 2001, given its very brief sojourn in the speculative grade category," the analyst added.

Fridson further pointed out that even were Moody's to abandon its well-established policy and decide to include Enron in its year-end speculative grade default rate calculations, it would have only a minimal impact on the rating agency's issuer-based default rate, which counts each defaulting company equally, no matter how many defaulting issues it may have outstanding or their total value. Enron, in other words, would only count as a single default, one out of many dozens.

Fridson acknowledged that Moody's principal amount-based default rate calculations - which are calculated using the dollar amount of defaulted debt - "would balloon in December." Even though only a portion of the massive $31.2 billion of debt the company listed in its bankruptcy petition is rated by Moody's and would thus be included in any calculations, the amount would still be in the billions.

"The extreme and spurious month-to-month volatility introduced by very large defaults is one reason why we [i.e., Merrill Lynch] emphasize Moody's issuer-based default rate in our analysis of risk premiums," notwithstanding the usefulness of the principal-amount series "in certain other contexts," Fridson concluded.

End

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