Moody's holds to 'benign' default rate forecast despite signs of weakening credit quality

By Paul Deckelman

New York, June 13 - Moody's Investors Service is sticking with what one senior official termed a "pretty benign" default rate forecast - even though the big credit ratings agency's data points to a weakening of overall credit-quality measures.

"We remain relatively comfortable with the current credit landscape," Christina Padgett, a senior vice president with Moody's corporate finance group, told participants at the New York Society of Security Analysts' annual High Yield Bond Conference on Wednesday.

"Our default rate forecast remains pretty benign."

Padgett, who leads Moody's leveraged finance practice, noted that the agency's U.S. default rate stood at 2.9% in May and is projected to fall to a "baseline" year-end level of 2.4% - although she allowed that if economic circumstances were to change, say with a sizable uptick in unemployment, "this forecast could change meaningfully."

Besides the "baseline" forecast, Moody's analysts have also speculated about potentially more pessimistic scenarios and, going in the opposite direction, more optimistic theoretical projections as well. The best-case forecast, were it to come to pass, would see the default rate dip below 2%, perhaps even approaching 1%, but the worst-case scenario would see it shoot up as high as around 7%. During the peak of the recession several years ago, with stressed-out companies defaulting left and right, the default rate in the summer of 2009 zoomed to around the 14% area.

Getting mixed signals

In her presentation, Padgett said that "at this juncture, I think it's fair to say that we are witnessing a contradictory set of circumstances" - a low default forecast amid weakening credit-quality measures.

For instance, Moody's maintains a list of issuers whose debt is rated at B3, with a negative outlook, or below - essentially, a list of distressed or soon-to-be-distressed credits. Currently, said Padgett, the list is "quite modest, with about 150 names, half of the roughly 300 names seen in March 2009." However, she said, "during the last three months, that list is starting to grow."

She said that ratings volatility - increases in the number of ratings changes - "is still modest, as a consequence of the small number of changes in ratings in the last few years, particularly relative to the last recession. However, we've been downgrading more than upgrading since last year, though the overall number is still low."

In April, nearly 30 ratings were downgraded against about 20 upgrades.

Padgett's colleague at Moody's, Lenny Ajzenman, noted a deterioration over the past few months in the covenant quality of new issues as measured by a new company index that measures the strength, or lack thereof, of various protections routinely written into high-yield bond indentures that limit the issuers' ability to make risky investments, pay dividends or buy back shares, incur additional debt, particularly if it is structurally senior to the bonds, and sell assets.

"Covenant quality remains weak. It has declined in all but two of the nine months since last July's peak," declared Ajzenman, a senior vice president with the corporate finance group. April's reading, he said, was virtually unchanged from March's, the lowest since Moody's began keeping score on covenants in 2011. May's level was a little better than April's but not by much.

In his presentation, Ajzenman noted a paradox: April's covenant-quality score was low, indicating an overall weakness in covenant protections, partially because the percentage of Ba-rated bonds, the top-rated junk tier in Moody's rating structure, increased to 41% of all of the new paper from a historical average of about 27%. The Ba bonds, which are the closest to investment grade, where restrictive covenants are considered to be largely unnecessary, "typically have weak covenant packages."

Fast forward to May, when Ba issuance fell to about 21% of the total. "This should have improved the index, because there were fewer Ba-rated bonds, but what we did see was weaker covenant quality at the lower end of the ratings scale" - the bonds rated Caa and Ca.

"Across the ratings categories, there has definitely been a weakening of bond covenants over the last three quarters," he said.

The weakening of covenant protection, particularly in paper rated Ba or below, "shows investors' willingness during this period to assume higher risk on higher-yielding bonds."

A cause for optimism

Despite those potentially troubling signs, other statistical measures paint a more positive picture.

For example, during her presentation, Padgett displayed a graph demonstrating that trends in high-yield bond spreads were historically consistent with the current benign default rate forecast.

Junk bond spreads, by most measures, are currently around or just over 500 basis points over Treasuries, coinciding with the relatively low default rate. In the run-up to the recession from around 2004 going into 2007, when default rates had been at their lows between a 1% and 2% annual rate, spreads at the same time were trending at their all-time lows of under 400 bps, and in some cases substantially under that mark.

Conversely, during the depths of the recession in 2009, with the default rate peaking at about 14%, spreads, slightly lagging defaults, were approaching their peak levels around 2,000 bps over Treasuries. However, they declined as steeply and almost as quickly as the default rates did once economic conditions started to stabilize and then slowly improve. By October 2010, defaults had plunged to about a 3.5% annual rate, while spreads had come back in to around 600 bps.

Padgett noted that Moody's chief economist, John Lonski, projects that spreads are likely to stay close to current levels, and he is "counting on the Fed not to change its [expansive low-interest-rate] policies just yet."

She said that current "remarkably low yields" have been the key driver in the flood of refinancing transactions that have dominated both the high-yield bond and leveraged loan spaces, and all of those refinancings and extended maturities have greatly cut down on refinancing risk as companies have been better-poised in the current environment to eliminate such risk by accessing the issuer-friendly loan and bond markets.

Padgett noted the key role that liquidity has played in keeping default rates down, since the lack of it has traditionally been a factor in ratings downgrades and defaults by companies unable to access the capital markets.

"The abundance of liquidity really is the main driver of low defaults. When liquidity goes away, defaults start to rise," she said.

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