Capital Markets

Bond-Default Dollar Volume Soars

While the number of defaulting issuers dropped last year, total dollar volume of bond defaults jumped 43 percentage points.
Marie LeoneFebruary 10, 2006

With six corporate issuers posting multi-billion dollar bond defaults in 2005, a precipitous rise in default-related dollar volume will refocus investors on credit quality, a new report from Moody’s Investor Service contends.

All told, 32 issuers defaulted on bonds in 2005, slightly fewer than the 36 that defaulted in 2004. At the same time, the total dollar volume of bond defaults jumped 43 percentage points to $29 billion, up from just $16.5 billion in 2004.

In the study, “Default and Recovery Rates of Corporate Bond Issuers, 1920-2005,” the authors explain that bond investors were spooked last year by Ford Motor Company’s and General Motors Corporation’s credit downgrades to “speculative”; defaults in cable, energy, and a handful of other widely-held industries; and a rise in the size of defaults.

Indeed, the biggest default came from within the cable industry. Charter Communications Holding LLC couldn’t meet its debt obligation and defaulted on $6.9-billion worth of debt in September. Power producer Calpine Corp. ran a close second, with a $6.7 billion default.

Joining Charter and Calpine in the billion-dollar default club were Delta Air Lines Inc. ($3.9 billion); Delphi Corp. ($2 billion); Calpine Generating Co. ($1.7 billion), a subsidiary of Calpine Corp.; and Northwest Airlines Inc. ($1.2 billion). Moody’s notes that those larger failures increased the average size of defaults in 2005 to $905 million, up from $457 million in 2004.

Nevertheless, the authors say, 2005 was a “positive year” for corporate credit quality because of low overall default rates and above-average recovery rates. (Moody’s calculates the default rate by dividing the number of defaulting issuers in a period of time by the number of issuers exposed to default risk during that period. The recovery rate measures an issuer’s success in reselling a defaulted bond.) Although the dollar volume of defaults spiked, overall default rates continued their four-year tumble, dropping to 0.6 percent in 2005 from 0.8 percent in 2004. In fact, even speculative-grade issuers–those most likely to default–saw default rates drop to 1.9 percent from 2.4 in the previous year.

Meanwhile, recovery rates came in at 56 percent, significantly higher than the historical average of 36 percent and a bit lower than 2004’s spectacular 60 percent recovery rate.

Nearly all of the beleaguered companies on the Moody’s default list are based in the United States, with the exception of Sweden’s Concordia Bus AB and Concordia Bus Nordic and Brazil’s Banco Santos SA. Further, most issuers were concentrated in a few troubled industries, specifically the auto and auto parts sectors (4 defaults) and the transportation sector (6 defaults).

Measured by dollar volume, the independent power sector topped the list as Calpine and its subsidiary racked up $8.4 billion worth of defaulted debt. The transportation and automobile sectors followed, posting $6 billion and $3.5 billion worth of defaults respectively. The study looked at 19 industry sectors in all.

As expected, most of the issuers that defaulted on bonds during 2005 were from the lowest tiers of Moody’s credit grading scale—B2 and below. However, there were two defaults by issuers that held investment-grade rating within a year of their default: Delphi Corp. and Entergy New Orleans Inc.

The authors explain that auto parts maker Delphi filed for Chapter 11 bankruptcy after failing to negotiate better wage and benefit terms with its union and secure financing from General Motors., its former parent and largest customer. Entergy NO, with bonds totaling $155 million, filed for Chapter 11 following Hurricane Katrina.

Looking ahead, Moody’s forecasts that the default rate for speculative-grade issues will rise from its current 1.9 percent level to 3.3 percent by the end of 2006. Although the credit quality of speculative-grade issuers remained steady in 2005–and the number of risky issuers dropped from to 219, down from 248 in 2004—gloomy macroeconomic trends will like boost default rates.

For instance, the consensus among economists is that gross domestic product growth for North America and Europe will slow in 2006. As a result, corporate profitability will falter, and so will the ability of bond issuers to service debt obligations, Moody’s predicted .

Further, the treasury yield curve flattened in 2005, as spreads between short-term rates and long-term U.S. treasury rates narrowed from 198 basis points at the end of 2004 to just 36 basis points by the end of 2005. Historically, that kind flattening “correlates with slowing economic growth and a rise in corporate defaults,” contend the authors.

What’s more, the “unprecedented increase” in the number of new issuers that occupy the bottom of the credit-rating scale–Caa and below accounted for 33 percent of the speculative-grade rated issuers in 2004–will eventually cause the aggregate default rate to rise by the end of 2006, predicts Moody’s.