Capital Markets

Low Distressed-Debt Ratio Signals Credit-Quality Boost

Down from 0.9 percent in May and 3.7 percent a year ago, Standard & Poor's distress ratio has remained below 1 percent for four straight months.
Stephen TaubJune 25, 2007

In yet another indication that credit quality is strengthening—
in defiance of experts’ predictions of a deterioration as the year progresses—the Standard & Poor’s U.S. distress ratio returned to its all-time low of 0.8 in June.

Down from 0.9 percent in May and 3.7 percent a year ago, the distress ratio has remained below 1 percent for four straight months.

S&P defines the distress ratio as the number of speculative-grade issues with option-adjusted spreads above 1,000 basis points per share divided by the total number of speculative-grade issues. A rising distress ratio signals increased urgent need for capital by companies most in need, says S&P, and is potentially a precursor to higher defaults, if accompanied by a credit crunch. On the other hand, if investors perceive credit quality to be strong, they will demand less of a premium to buy newly issued debt.

Low distress levels are not the only signs of strong corporate credit quality, however. S&P points out that in the U.S. leveraged-loan market, the share of performing loans trading at prices less than 80 cents on the dollar—a key barometer–has been recording near zero rates since December 2005.

Over the long term, movements in the distress ratio correspond well to trends in the speculative-grade default rate, with a peak in the distress ratio generally signaling a peak in default rates about nine months later, it points out.

Even so, the distress ratio displays a great deal of variation when broken out by industry, S&P notes. As of June 15, distressed issues across eight sectors cumulatively accounted $2.1 billion worth of debt, slightly lower than the $2.4 billion reported last month.

Based on debt volume, health care comprised the largest portion of the total, accounting for more than 22 percent, according to S&P. At the same time, more than half of the sectors listed have distress ratios of zero, meaning that no issue is trading at 1,000 basis points above Treasuries.

S&P warns, however, credit quality is poised to deteriorate somewhat. Although the near-term outlook for defaults is still relatively benign, a sustained period of increased lower-grade issuance—defined as ‘B- or lower–since 2003—serves as a warning of rising default pressure ahead.