Junk bonds are looking more attractive, at least for the time being, as speculative-grade default rates hit their lowest point in 25 years, according to Moody’s Investors Services. Junk-bond default rates fell from 1.80 percent in 2005 to 1.57 percent in 2006, marking the fifth consecutive yearly decline, and the lowest year-end drop for this sector since 1981, says Moody’s.

The junk-bond default rate drop is consistent with overall levels. The default rate for all Moody’s-rated corporate issuers fell to 0.54 percent in 2006 from 0.65 percent in 2005, the lowest level in a decade.

But the good news may not last long. Although 2006 was “an unexpectedly strong year for the riskiest corporate debt issuers…the credit quality pendulum appears set to swing in the opposite direction in 2007,” warned Moody’s David Hamilton in a press statement. Moody’s predicts that the pace of junk-bond defaults will nearly double during 2007, rising to 3.07 percent by the end of the year. While the rate is trending up, it is still below the average annual rate of 4.9 percent.

The report explains that a turn in the credit cycle that was expected to happen in 2006 may take place this year instead. “Market liquidity was a crucial factor in keeping the default rate temporarily low in 2006, but we do not believe the relationship between fundamental credit quality and subsequent default rates has changed,” reasoned Hamilton.

Hamilton, Moody’s director of corporate default research, cites the correlation between when the bonds are issued and their initial “low” credit quality to explain why 2007 may be the year of more defaults. “The cohorts of risky debt issuance of 2003 and 2004 will soon be reaching the period when default risk has historically been highest, in the third and fourth years after issuance,” he contends. Many of the junk bonds issued during this period were rated below single B and, as a result, Hamilton expects default rates to climb in 2007 and 2008.

Dana Corp., together with Dana Credit Corp., was the year’s largest default with approximately $1.9 billion of debt. The financially troubled automobile-parts sector saw the highest volume of defaults last year, at $2.8 billion, which is more than one-third of the total defaulted bond volume for 2006. The sharp decline in default volume resulted in a similarly sharp drop in the default rate measured on a dollar-volume basis.

Junk-grade defaults by dollar volume fell from 3.85 percent in 2005 to 1.05 percent in 2006. That fall was caused mostly by several large defaults in the airlines and telecommunications sectors that skewed the calculation in 2005.

Worldwide, 33 rated corporate issuers defaulted on a total of $7.8 billion of bonds and $3.1 billion of loans in 2006, compared with 2005, when 34 issuers defaulted on an aggregate $41 billion of debt (bonds plus loans). Corporate defaults were concentrated in the United States last year, where 26 issuers defaulted on an aggregate $9.1 billion of bonds and loans. Five corporate issuers defaulted on $1.6 billion of debt in Europe, and two bond issuers based in South America defaulted on a total of $167 million.

Leave a Reply

Your email address will not be published. Required fields are marked *