Capital Markets

Credit Quality Shows Cracks

Is a crisis lurking around the corner?
Stephen TaubNovember 13, 2006

Despite predictions by credit agencies and hedge fund managers of an erosion in corporate credits for the past year, credit quality has remained strong. Now, however, there are some subtle signs of a shift.

To be sure, the U.S. speculative-grade default rate fell to 1.9 percent in October from a revised 2.1 percent rate at the end of September. At the same time, Standard & Poor’s points out in a new report that just 26 issuers have crossed over to investment grade from speculative grade in the year to date. That is the lowest such figure since 2003 and well below the 44 issuers that crossed over in the same period last year, according to the rating agency.

Meanwhile, the total number of global fallen angels—companies that have descended from investment-grade to speculative grade credits—
continues to outpace rising stars by a margin of 14 entities, a reversal of the pattern seen in 2004 and 2005, according to S&P.

There are, nevertheless, no serious signs of weakness, according to S&P. But Diane Vazza, head of S&P’s Global Fixed Income Research Group, said this in a press release: “Looking ahead, rising star activity should continue to decelerate with the anticipated turn in the credit cycle.”

Meanwhile, in a separate report, S&P pointed out that there were four defaults in October among speculative-grade credits, the single biggest monthly count in 10 months. That brings the year-to-date total to 22 defaults.

That doesn’t exactly indicate a crisis. The 12-month trailing global corporate speculative-grade bond default rate increased to just 0.98 percent in October from a 24-year record low of 0.94 percent in September. It also falls far below the long-term (1981-2005) average of 4.61 percent for 33 consecutive months.

By the end 2006, however, Vazza expects the default rate to rise to 1.4 percent—although she is quick to point out that that would be “a near-record low.”

In 2007, S&P predicts, the default rate will edge up slowly from its 2006 trough, reaching 2.4 percent by mid-year and 3.2 percent by year-end 2007. The agency expects the U.S. speculative-grade default rate to remain below the long-term average of 4.7 percent but warns that default rates among U.S. leveraged loans are also expected to increase.

Moody’s is a bit more optimistic. The rating firm recently calculated that the global speculative-grade default rate ended October at 1.7 percent, unchanged from its revised level in September. This is where it expects the default rate to end 2006. Even so, Moody’s predicts that the default rate will then rise to 2.5 percent by the end of October 2007.

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