Global bond markets' weakest links

The global corporate speculative-grade bond default rate rose to 1.79% at the end of August, marginally higher than the eight-year low of 1.58% recorded in March 2005. The global speculative-grade default rate has remained below the long-term (1981-2004) average of 4.95% for 21 consecutive months, but is still higher than the record low of 1.28% posted in the second quarter of 1997.

The near-term default outlook has been mostly sanguine owing to expectations of relative economic stability, relatively favorable financing conditions, and healthy corporate profitability, with the global default rate edging up slowly from its trough before the end of 2005. In the US, results from a proprietary default forecast model indicate that US speculative-grade default rates will continue to edge up slowly over the next few quarters, reaching 2.41% by the second quarter of 2006 (results based on running the model on Sept. 2, 2005).

The average forecast for the next four quarters (2.17%), however, remains about even with the historical average of the trailing four quarters (2.19%). As of Sept. 6, 2005, a total of 19 entities remained vulnerable to default on rated debt worth US$9.6 billion, one more than a month earlier but lower than the average of 30 entities recorded over full-year 2004. These weakest-link issuers are defined as issuers rated 'CCC' or lower with either a negative outlook or ratings on CreditWatch with negative implications. US-based issuers (including tax havens) constituted 15 of 19 issuers.

In the US and - to a lesser extent - in Europe, a rising proportion of lower-grade issuance ('B-' or lower) beginning in 2003 serves as an early warning of renewed default pressure within two years. In the first eight months of 2005, the proportion of lower-grade issuance in the US remained high at 44% compared with 43% on average in 2004.

For full-year 2003, the proportion was 31%. Bond spreads on speculative-grade issues have already turned around from their record lows, even though some of the widening seen in April and May has evaporated in recent weeks.

A gradual widening in the 375 basis points (bps)-475 bps range will continue the rest of the year, though no blowout is expected. At 40%, the proportion of lower-grade issuance was also high in Europe in the first eight months of 2005; although slightly slower than the pace set in 2004 (45%), it has remained at more than 30% for seven consecutive quarters. The small size of the high-yield market in Europe accentuates volatility and limits direct comparison with the US

Results from Standard & Poor's Ratings Services' proprietary default forecast model for the US speculative-grade bond market indicate that default rates will slowly edge up over the next few quarters (results based on running the model on Sept. 2, 2005). By the end of the second quarter of 2006, a default rate of 2.41% is expected.

The average forecast for the next four quarters (2.17%), however, will remain even with the historical average of the last four quarters (2.19%). The gap between model projections and actual default rates was erased in the most recent quarter, and the prior divergence remains well within the model's 95% prediction interval of about plus or minus 1.3% (see Chart 1).

The main drivers of the model include the unemployment rate, the slope of the yield curve, aggregated corporate profits, and the outlook distribution of Standard & Poor's-rated speculative-grade issuers. Together, these inputs explain 85% of the observed variation in the US speculative-grade default rate over time.

The interaction between the dependent variable (i.e., the US speculative-grade default rate) and the input variables is in line with expectations. Changes in variables - such as the unemployment rate and the outlook distribution - are positively correlated with the speculative-grade default rate, which means that as unemployment rates increase or as the proportion of entities rated with a negative bias rises, default rates accelerate.

Chart two displays the correlation between the rate of change in the unemployment rate and speculative-grade default rates in the US Conversely, a steeper yield curve - widely associated with an economic recovery - tends to coincide with a decline in speculative-grade default rates. An increase in corporate profits is also intuitively associated with a decline in default rates.

The decline in the speculative-grade default rate has been accompanied by a visible easing of lending conditions, especially in the US, as reported in the Federal Reserve Loan Officer Opinion Survey on Bank Lending Practices. In the latest survey - conducted in July - a net percentage of 17% of domestic banks reported easing standards for large and midsize firms, a slight decrease relative to the April survey (see Chart 3).

The net percentage of banks reporting easing standards for small firms decreased to 11% in July, from 24% in April. Institutions that reported easing of lending standards, in the past three months cited more aggressive competition from other banks or nonbank lenders as an important factor in their decision. Furthermore, the proportion of distressed credits in the US - defined as speculative-grade-rated issues that have option-adjusted spreads of more than 1,000 bps - declined in 2003 and appears to have bottomed out in 2004 and early 2005.

The distress ratio was 5.7% at the end of August, below the 7.0% average for full-year 2004. Weakness was centered in the automotive and telecommunications sectors, which together constitute more than 40% of the total number of distressed issues. The movement in the distress ratio parallels the movement in the speculative-grade default rate (see Chart 4).

(For more detail on distressed issues, refer to the July 21, 2005 report titled "US Distressed Monthly Monitor," available at www.standardandpoors.com/gfir and on RatingsDirect.)

Default rates in the US leveraged loan market have also remained muted, inching up to 1.51% at the end of August compared with 1.12% at year-end 2004. Defaults in the remainder of 2005 are expected to remain subdued in this segment though higher than the lows of one year ago. Liquidity remains plentiful, and the distress ratio - measured as the percentage of performing loans in the US trading below 80 - still remains near record lows (see Chart 5).

Along with supportive liquidity conditions, signs of deceleration eased in the manufacturing sector, which, along with the unemployment rate, is a good leading indicator of the speculative-grade default rate. The Institute of Supply Management's overall index of manufacturing activity slipped to 53.6 in August after a more solid reading of 56.6 in July.

After six consecutive months of decline that resulted in the year's lowest reading of 51.4 in May, the last few months have been more stable based on strength in both the orders pipeline and production indicators. August marked the 27th consecutive reading greater than 50 and the longest sustained expansion since the late 1980s.

Meanwhile, gains in EU industrial production continue to hover around zero (relative to 12 months ago) despite improvements in the past year (see Chart 6). Signs of activity in the Eurozone were relatively subdued.

Growth in Eurozone manufacturing activity expanded slightly in July and August for the first time since March, according to the NTC Research purchasing managers' index (PMI). However, both July and August saw very little growth, with the PMI dropping to 50.4 in August from 50.8 in July.

New orders expanded in August, as the Eurozone index for new orders recovered to 51.7 after retreating to 48.5 in May. Weak domestic orders continue to hold back total new orders. Manufacturing activity across the Eurozone has been pressured during much of the past year by the strong euro, softer global growth compared with the first half of 2004, powerful international competition (particularly from Asian and Eastern European companies), high oil prices, and persistently subdued domestic demand in many Eurozone countries (most notably, Germany and Italy).

Results from the European Central Bank-conducted Euro Area Bank Lending Survey in July also showed a more pronounced increase in the net percentage of banks reporting easing credit standards (see Table 1). For the fifth time in the survey's short history, more firms eased than tightened credit standards, partly in response to increased competitive pressure from other banks.

The net easing was achieved primarily through a strong decline in margins on average loans and a lengthening of loan maturity. In addition, banks reported that loan covenants and collateral requirements became less stringent, while noninterest rate charges were eased and the average size of loans or credit lines was increased.

Lending to larger companies experienced the greatest easing in the most recent survey, although small and midsize enterprises continued to remain beneficiaries of net easing policies. Abundant liquidity has been an important factor in averting defaults, which in turn has facilitated spread compression.

Globally, the speculative-grade default rate remained low at the end of August after steadily declining during most of 2004. At 1.79%, the 12-month rolling global speculative-grade default rate rose from its eight-year low of 1.58% recorded in March but remains a fraction of its long-term (1981-2004) average of 4.95% (see Table 2).

The US recorded a speculative-grade default rate of 2.27%, which is also lower than its long-term (1981-2004) average of 4.89%. European speculative-grade default rates remained low (0.56%) at the end of August versus 0.63% 12 months earlier. In the emerging markets, a 0.66% default rate was recorded at the end of August versus 0.47% six months earlier.

Three emerging markets defaults have been observed in the trailing 12 months: OAO NK Yukos of Russia, Administracion Nacional de Combustibles Alcohol y Portland of Uruguay, and one confidentially rated corporate default.

In the US, the highest default rates by industry in the trailing 12 months were recorded in the transportation sector (see Table 3).

In the first eight months of 2005, 23 defaults have been recorded, affecting rated debt worth $8.3 billion, compared with a total of 49 defaults in full-year 2004 affecting debt outstanding worth $16.2 billion. In August 2005, three defaults were recorded: a US-based glass container manufacturer (Anchor Glass Container Corp.), a US-based metals company (ASARCO LCC), and a US-based credit institution (Foamex L.P./Foamex Capital Corp.).

Of the total recorded in the year to date, the US recorded 18 defaults affecting rated debt worth $7.9 billion. Five other defaults recorded in 2005 were based in Japan, Canada, Sweden, and Uruguay. As of Sept. 6, 2005, a total of 19 entities remained vulnerable to default, with rated debt worth $9.6 billion.

These weakest-link issuers are defined as issuers rated 'CCC' or lower with either a negative outlook or ratings on CreditWatch with negative implications. Negative outlooks and CreditWatch placements serve as good leading indicators of actual downgrades. A long-term study recently published by Standard & Poor's Global Fixed Income Research corroborates this unequivocally (see report titled "CreditWatch and Ratings Outlooks: Valuable Predictors of Ratings Behavior," published May 26, 2005 on http://www.standardandpoors.com/gfir as well as on RatingsDirect). CreditWatch status and outlooks are strong predictors of ratings behavior, both in the aggregate as well as when broken out by rating category, region, or sector. For example, of all ratings that are 'CCC' or lower on CreditWatch with negative implications, 54% are lowered.

The current list of 19 weakest links is one more than the number reported a month earlier and fewer than the average of 30 entities recorded in 2004. Since the last publication, four entities were removed from the list, and five issuers were added. The removals resulted from two defaults - US-based Anchor Glass Container Corp. and US-based ASARCO Inc. - and two entities from the previous list are no longer rated ( Levitz Home Furnishings Inc. and Waddington North America Inc.).

Meanwhile, three US-based companies were added to the list as a result of downgrades ( Bally Total Fitness Holding Corp., Home Interiors & Gifts Inc., and Panavision Inc.) and two as a result of unfavorable CreditWatch revisions ( Delta Air Lines Inc. and FLYi Inc.). For a full list of this month's weakest links, see Table 5 and Table 6.

With seven issuers, the media and entertainment sector showed the highest vulnerability to default among the weakest links, constituting 37% of issuers and 21% of volume (debt outstanding) on the most recent weakest links list (see Table 4). Next in line were the transportation and consumer products sectors, with three and two issuers, respectively.

Geographically, US-based issuers (including tax havens) featured disproportionately on the weakest-links list, accounting for 15 of 19 issuers. This preponderance is attributable to the higher ratings penetration in the U.S. marketplace. Elsewhere, two issuers from Europe (UK and Italy) and two from Latin America (Brazil and Belize) were among the weakest links.

In the US, the share of new issues rated 'B-' and lower as a proportion of total speculative-grade issuance was 44% in the first eight months of 2005, higher than the 43% and 31% averages recorded in full-years 2004 and 2003, respectively (see Chart 7). Within the lowest-rated segments, issuance rated 'CCC+' showed the fastest growth in 2004 (based on both issue count and volume).

The proportion of issuance rated 'CCC+' and lower remains high, rising to 17.8% as a share of total speculative-grade issuance during the first eight months of 2005 from 16.4% in 2004 and 8.3% in 2003. In the first eight months of 2005, the share of issuance volume rated 'B-' or lower to total speculative-grade issuance was especially high in the broadly defined industrial sector.

More specifically, health care was the leading issuer in the year-to-date, with $3.2 billion in issuance occurring in the corporate health care segment, where consolidation opportunities and share repurchases head the list of reasons for health care companies to increase their debt usage. In addition, other industrial subsectors such as consumer products, media and entertainment, automotive, and retail/restaurants each issued more than $1.0 billion during the first eight months combined.

At 40% in the year-to-date 2005, the proportion of lower-grade issuance was also high in Europe but lower than the proportion for full-year 2004 (45%). However, the small size of the high-yield market in Europe accentuates volatility and limits direct comparison with the US high-yield market.

The pace of 'B-' issuance in Europe increased to 50% in the second quarter of 2005, up from 36% in the first quarter - its highest level since the first quarter of 2001.

Issuance generated at the 'B-' level and lower is typically a breeding ground for potential defaults. Historical experience shows that over the long term (1981-2004) globally, an average of 12.1% of all entities rated 'B-' and 29.0% of all 'CCC' or lower rated entities transition to default within one year. At higher ratings, the average one-year transitions to default are much lower (e.g., 8.3% for 'B' rated entities, 3.0% for 'B+' rated entities, and 1.8% for 'BB-' rated entities). The previous spike in low-grade issuance at these rating categories during 1997-1999 subsequently led to a peak in defaults in 2001 (see Chart 7). During this period, the share of speculative-grade companies with issues rated 'B-' or lower consistently exceeded 30%. The current proportion has remained higher than 30% for eight consecutive quarters in the US and seven in Europe, which serves as an early warning that the speculative-grade default rate could peak again within two years (i.e., 2006 and beyond), which is typically the length of time between elevated issuance and higher defaults.

[The article is an abstract from RatingsDirect, Standard & Poor's Ratings web-based credit research and analysis system (www.ratingsdirect.com). To learn more, please click on About RatingsDirect.]