Banking & Capital Markets

Positive Indicators Seen For Credit

Some of the latest stats may be good news for issuers who hurry.
Ed ZwirnApril 9, 2001

Credit quality is declining, default rates are rising, and the stock market is in turmoil.

But entrepreneurial types who think that there is no light at the end of the funding tunnel may be too pessimistic.

Senior financial executives should be aware that the latest evidence from some analysts indicates that a dramatic increase in opportunities to tap the debt market may soon be in the offing, and that this increase may have enormous implications for the economy as a whole.

For the first time since they began rising, default rates for speculative bonds are forecast to come down, according to David Hamilton, assistant vice president of Risk Management at Moody’s Investors Service.

Of course, things are going to get worse before they get better.

Don’t Worry, Be Happy

For the 12 months ending March 31, defaults of bonds rated Ba and lower by Moody’s were occurring at a rate of 7.1 percent, Hamilton notes.

The ratings agency made headlines in December and January with a forecast showing the default rate for calendar year 2001 at 9.5 percent. Others, such as Standard & Poor’s were also agreeing that defaults would go up, and both had been noting since September 2000 that overall downgrades had been exceeding upgrades by a ratio of about four-to-one.

These pronouncements were understandably viewed as further corroboration of predictions that credit conditions were worsening and the economy slowing down.

Indeed, Hamilton is in fact predicting that the default rate will continue to climb over the next several months, peaking at 9.9 percent in February 2002 before starting on a downward slope in March with a reading of 9.7 percent.

This 9.9 percent peak prediction, if proven accurate, would contrast favorably with the 13 percent actual default rate hit in July 1991, “the peak for the modern high-yield era so far,” Hamilton said.

Back then, Moody’s predicted the correct month when defaults would peak, although Hamilton noted that its “model understated the forecast” at 10.2 percent.

Inflection Point

Hamilton says the prediction then and now is based upon certain factors that are easy to model.

  • High-yield issuance peaked in 1997 and 1998. The normal “seasoning” factor would predict that the default rates of particular bonds peak at around the four-year point, which is what is happening now.
  • The Treasury yield curve, an important measure of the extent to which investors are compensated for loaning money over time, began late last year to reverse the negative slope it had exhibited throughout most of Y2K. By February of 2001, the slope of the 90-day to 10-year curve was firmly in positive territory.

The Moody’s prediction would nicely dovetail into the rule of thumb that suggests a comeback for credit quality follows by “one year to one year-and-a-half” a shift to a positive yield curve.

“In this case, it works out to 15 months exactly,” he said.

In the meantime, evidence continues to suggest that tight lending policies are tighter than ever.

A report by Martin Fridson, Merrill Lynch’s chief high-yield strategist, notes that the Federal Reserve Board’s survey of bank loan officers said that respondents reporting tighter lending practices came to 59.7 percent last month.

“This is the highest level since the Federal Reserve began asking this question in 1990,” he said.

“You still have some negatives out there,” says Hamilton. “Such as poor credit quality, and high default rates.” The percentage of outstanding high-yield bonds rated B or less is at a very high 72 percent, he added.

But other factors, such as the slope of the yield curve and a declining interest rate environment add up to one thing, according to the Moody’s analyst:

“We are definitely at an inflection point,” he said, defining “inflection point” as the definable moment when your slopes begin to change and your model becomes less negative than it had been.

Good Time For Issuance

What does this mean for the economy in general and corporate funding in particular?

The bottom line for finance executives:

“If we are nearing that sort of late phase when things will turn around this is going to be positive for issuance [and] issuers can take advantage of this ahead of the turnaround,” Hamilton said.

Pipeline Filling Up

In the meantime, issuers of both investment grade and junk bonds are seeing a decent reception for new issues. But spreads continue to widen all the same for the more speculative-rated instruments, driven in that direction by both stock market volatility and overall concern about the economy on the part of investors.

In investment grade, which has seen the value of issues go up or down in a clear inverse relationship to the stock market, the new issues that have priced over the past volatile week have gone off largely without a hitch, and at spread levels tighter than forecasted.

PSE&G, the New Jersey utility, was reportedly seeing strong demand for the $1.6 billion of five, seven-, and 30-year notes it was trying to peddle as of Friday afternoon.

The Baa1/BBB+-rated deal had been slated to price this week, but as of Friday underwriter Morgan Stanley Dean Witter may have been ready to go ahead anyway, and at levels 10 basis points tighter than the tight range of forecasts that had been announced Wednesday.

In another of last week’s investment-grade deals, John Deere Capital’s pricing of $250 million of A2/A+-rated five-year notes was said by market sources to be driven less by operational necessity than by “opportunistic” impulses.

“Opportunistic” as in the folks at John Deere Capital being unable to resist the temptation to borrow the money at an effective yield of 5.906 percent, or 136 basis points over Treasuries, a far cry from the yield offered by parent John Deere & Co. when it hit the Street with $300 million of 30-year 7.125 percent notes early last month.

Investment grade issues to watch this week and over the coming weeks include:

  • Delhaize America, a supermarket holding company, which is expected to issue $2 billion of 10-year (Baa3/BBB-) senior subordinated discount notes via a private 144A offering led by Deutsche Bank Alex. Brown, J.P. Morgan Chase, and Salomon Smith Barney.
  • Health Net, a major California health insurer, which plans $300 million of intermediate-term bonds via J.P. Morgan Chase and Banc of America Securities, which are expected to carry Baa3/BBB- ratings, one notch above “junk.”

Junk issuance is also expected to be fairly busy going forward:

  • Tricon Global Restaurants, the folks who gave “junk” a whole new meaning by owning the Kentucky Fried Chicken, Pizza Hut, and Taco Bell chains, plans to sell $750 million of (Ba1/BB) bonds to repay bank debt. Pricing of the offering is expected as soon as this week, according to market sources. The sale will be managed by Goldman Sachs, J.P. Morgan Chase, and Salomon Smith Barney.
  • AGCO Corp., a farm equipment manufacturer, will sell $250 million of high-yield bonds this month, also to repay bank debt. Pricing of the (BB/Ba2) notes, which will mature in 2008, is expected to follow soon after investor meetings wrap up Wednesday.

Other names on the high-yield calendar include FiberMark ($225 million of 10-year senior B1/BB- notes), Davita ($200 million of 10-year senior subordinated B3/B- notes), and United Rentals ($300 million of senior B2/BB- notes).

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