Should investors be worried by corporate defaults?

9th February 2012

A survey by the FT of the leading analysts showed that many have raised expectations of corporate defaults since the start of the year: "BNP Paribas predicts that the corporate bond default rate will rise from the current 2.6 per cent to 4 per cent by the end of 2012 but others are more bearish. Morgan Stanley predicts 5 per cent; RBS forecasts 5.6 per cent and Bank of America Merrill Lynch 5.9 per cent."

S&P had already raised its speculative grade default rate expectation to 6.1% for 2012, the equivalent of 41 companies defaulting by the year end. It also said that if conditions worsened the default rate could rise as high as 8.4%.

How scary are these figures? S&P points out that they are still a lot lower than at the peak of corporate failures in the last crisis: "By comparison, in the third quarter of 2009 the trailing 12-month default rate reached 14.7% in Europe, so the outlook for 2012 is milder than in 2009. The agency also believes that investment grade and high-rated speculative grade companies are generally better positioned to cope with a recession than they were in the fourth quarter of 2009, having adopted more conservative financial policies to reduce leverage."

The group suggests that companies operating globally will be better insulated, compared with those that operate within Europe – particularly those exposed to the PIIGS economies.

However, there appears to be some deterioration in credit conditions. The FT piece quoted a European Central Bank survey showing tighter credit conditions in the last three months of 2011, with banks reporting that they expected lending conditions to deteriorate further this year. 

Moody's also reported an increase in the corporate failure rate: "In the U.S., the rate of corporate failure rose to 2.2 percent from 1.8 percent in December. In Europe, the number was unchanged at 3 percent. The global rate could rise to 2.7 percent by January 2013.

"Default rates remain low by historic standards, but they are increasing, particularly in Europe," Albert Metz, managing director of credit policy research at Moody's, said in the report. "We expect more defaults in the coming months. But our baseline case remains that default rates will remain below their long-term average."

John Pattullo is similarly sanguine about the outlook for defaults: "Default rates are hard to estimate. There are a relatively low number of businesses with quoted bonds that could default, but nonetheless the market seems untroubled for the time being. It has come out of the gates very strongly in January and is up around 8.5%. The market was very cheap, but LTRO has also been influential.

He says that this strength has meant that a number of marginal companies have been able to refinance, adding: "These were the marginal high yield credits – CCC-rated and 7x leveraged. A lot have been refinanced by US high yield investors." This is likely to keep the default rate relatively low for the time being, though these businesses are still struggling with significant debt and may not be viable in the long-term.

Patullo's view is supported by this piece in the FT, which shows the record demand for low-grade corporate debt so far this year: "Markets on both sides of the Atlantic have rebounded as concerns about the global risk from Europe's debt crisis have eased. The larger and more liquid US market has also benefited from a pledge by the Federal Reserve to keep interest rates near zero through to 2014, prompting income-seeking investors to hunt for assets with the highest yields.

"US funds that buy junk bonds have taken in net cash of $9.4bn this year while similar European funds have had net inflows of $81m."

A weaker economic environment will inevitably bring higher defaults, but until recently this was priced into markets: ""The sell-off in the high-yield market fully priced in a global recession, led by a slowdown in Europe," said Michael Collins, senior investment officer with Prudential Fixed Income. "Investors are getting compensated for a default rate of about 7%, which is a much more dire scenario than I think is reasonable."

The market's strength has helped some companies to refinance and is likely to keep the default rate relatively low for the time being. The time to worry would be if the high yield market continues to soar and the expectation of a weakening default rate was no longer factored into prices.


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