16/03/2007
Company Defaults – What Will Drive Them Higher?
The health of the corporate bond market is intimately tied to the level of company bankruptcies and defaults. Given that most financial pundits are predicting higher company defaults, should bond investors be worried?
Certainly, default levels are unlikely to reduce. Standard & Poor's 12 month trailing global corporate speculative grade bond default rate fell to an almost record low of 1.09% in 2006, and has now been below the long term (1981-2005) average of 4.5% for 35 consecutive months. However vigilance rather than paranoia is the order of the day. Similar to 2005 and 2006, default levels should be at the lower end of current market expectations of 2.5-3% by the end of 2007.
There are 3 broad drivers for default levels,
- economic conditions
- company credit quality
- liquidity
Starting first with economic conditions. The expected economic slowdown in the US will cause some pressure and there is traditionally, a reasonable correlation between when the US Fed stops raising interest rates and rising default levels. However the US economy is likely to see slower growth rather than outright recession and the global economy should remain relatively robust. Default pressures from this source alone should be contained.
The same is true with company credit quality which remains reasonably underpinned, despite the growing divergence between investment grade and high yield sectors. Strong profitability is supporting investment grade company credit fundamentals. We are likely to see some pressure in 2007, fuelled by debt financed acquisitions and lower earnings growth, but it should not be dramatic.
High Yield credit quality is under more pressure. Leveraged Buy Out (LBO) debt issuance has surged in recent years with mostly negative credit implications;
- leverage multiples are at very high levels
- Private equity owners frequently take out their equity at the earliest opportunity
- frequent debt recapitalisations means that companies are not reducing debt when times are good, making them more vulnerable when times get tough.
Liquidity conditions is the main reason why defaults have remained lower for longer, as ample global liquidity means that refinancing is relatively cheap and easy for even vulnerable companies. Bank lending conditions still look relatively loose. In the latest Federal Reserve Loan Officer Opinion Survey on Bank Lending Practices, for example, 5.4% of the largest banks have eased lending standards, compared to 2.7% who have tightened them.
Even although banks have got tougher, a number of companies have just re-financed through the bond market at similar cost but less restrictive covenants. Investor demand for yield, and benevolent economic conditions have meant the bond market is readily swallowing a high proportion of the more risky, lower-grade issuance ('B-' or lower).
Finally, the massive amount of leverage involved in the collateralised synthetic obligation (CSO) market (debt obligations packaged together using further debt) also supports liquidity, reducing company funding costs and helping banks hedge loan risks.
Whilst liquidity conditions should remain supportive in 2007, this excessive liquidity means that when the tide turns, many companies will be stranded. Leaving aside recessions, when liquidity is always quickly turned off, l iquidity conditions could quickly change due to;
-
Problems with large LBOs hitting risk appetite and bank balance sheets
- problems with CSOs due to a small number of defaults, but by companies who are found in most CSOs
We expect defaults to rise more slowly in 2007 than most people predict, reinforcing what should be a reasonably constructive credit environment. However, overall liquidity levels will still need to be carefully monitored.
BULL
- investment grade company credit quality
- ample global liquidity reinforces search for yield
- defaults unlikely to rise dramatically
Bear
- margin for error is low for some high yield companies
- US housing weakness could cause negative economic surprises
- Over reliance on liquidity will leave many companies vulnerable when global conditions finally get more difficult
Craig MacDonald, Investment Director – Fixed Interest, Standard Life Investments
First published in Investment Week on 19 February.
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