As Credit Deteriorates, Is a Crunch Avoidable?

Downgrades have exceeded upgrades for 10 consecutive quarters, and the trend is accelerating. Will the market for investment grade issuers shut down?
Ed ZwirnDecember 8, 2000

U.S. corporate credit quality has now declined for the longest period since the early 1990s. And preliminary figures from the major ratings agencies show the trend worsening this quarter, particularly for companies with more speculative ratings.

But there are important differences between now and the early 90s. This time, the economy is not in a recession and nearly nobody is forecasting one for the near future.

And despite a slowdown in capital borrowing markets, things are not shutting down, economists from both Moody’s Investors Service and Standard & Poor’s argue. Investment-grade companies, at least, should continue to be able to raise funds at reasonable costs going into 2001.

That being noted, both agencies show that, counting the current quarter, upgrades have exceeded downgrades for the past 10 consecutive quarters, or since the foreign- inspired “credit market meltdown” of late 1998.

At that time, market mishaps from Malaysia to Moscow prompted domestic concerns over liquidity and caused the Federal Reserve to shift over to a loosening mode.

Increasing Defaults Cited

Now, rising costs of energy, labor and borrowing itself have shrunk margins in just about every industry. Also, in the classic boom-bust cycle logic, liquidity concerns are also surfacing as banks, which had loosened lending practices over the past few years, are seeing what is perhaps the inevitable outcome of this practice: increasing defaults.

Since the end of September, both Moody’s and S&P show overall downgrades exceeding upgrades by a ratio of about four-to-one. Investment grade issuers have fared somewhat better, their ratio being in the neighborhood of three- to one, while in high yield the figure is much higher–five-to-one–according to figures compiled by S&P.

In a further bit of bad news for would-be junk bond issuers, a report recently issued by Moody’s predicts that defaults on speculative issues will increase to 9.1 percent over the coming 12 months, up from the 8.4 percent default rate forecast for the ensuing 12 months back at the end of October and a sharp rise over the 6.02 percent default rate forecast by the agency for all of 2000.

And credit seems to be deteriorating across all sectors of the economy.

All Sectors Suffer

Diane Vazza, head of global fixed income analysis at S&P, says that investment-grade downgrades have hit “across the board” in sectors as spread out as consumer products, financial institutions, forest products, media and telecommunications.

And in junk, the locations of the bad news are “even more diverse,” she says, singling out for special mention sectors including auto supplies, chemicals, transportation, mining, media and retail restaurants.

“Certainly, we’re in for a tough time in the first half [of 2001] whether there is a hard or soft landing,” she tells

Vazza details the woes facing high-yield issuers in particular, pointing out that investors in some U.S. corporate junk bonds, believe it or not, are demanding spreads of as much as 1,000 basis points (or a full 10 percent) over Treasuries.

This is some 400 to 500 basis points wider than comparable spreads which prevailed 12 months ago, she says. The result: “The high- yield market in December has basically come to a screeching halt. Spreads in investment grade have widened out but not to the same extent.”

John Puchalla, a Moody’s economist, says that while liquidity concerns have hit the high- yield market with the heaviest hammer, a general business slowdown also isn’t helping. “In the high-yield sector [credit is being hurt by] a combination of slower earnings growth and weaker liquidity,” he says. Issuance in junk land is off “about 70 percent from last year.”

He points out that while a general increase in basic costs such as energy and labor have hurt major manufacturers more so than other industries with more flexible cost structures, the top line is also being squeezed. “Year-to year business sales for all industries are now growing by only 5 percent, compared to around 10 percent in the first quarter, and that’s a drop of about half,” adds Puchalla.

Don’t Worry, Be Happy

But the Moody’s economist tempered this statistic by noting the economy was bound to come down from the stellar heights at which it stood early this year. “Basically, retail sales were growing very strongly in the first half of this year,” he says. “You can’t have consumer spending growing at 11 percent indefinitely.”

And the verdict is mixed so far on this year’s holiday spending. “The weekend after Thanksgiving was pretty good, but things have slowed down for the first week of December,” he says.

Further, Puchalla sees other more definitive reasons for optimism.

First of all, “we are not in the late 80s,” he adds. The Federal Reserve has a “freer hand than it did then, when inflation was such a concern.”

Also, he says, statements by Fed Chairman Alan Greenspan indicate that the Fed is recognizing that a slowdown may be in progress and may be ready to ease.

He adds, “If the Fed is seeing this and starts to loosen monetary policy, this could have some positive effect and prevent a full-blown credit crunch.”