Capital Markets

It’s a Junk World after All

A Standard & Poor's report says new issues, not downgrades, are driving the prediction that speculative-grade bonds will outnumber investment-grade...
Stephen TaubAugust 3, 2007

What a difference loose credit makes. In the second quarter of 2007, there were more speculative-grade entities (51 percent) than investment-grade entities, according to Standard & Poor’s — marking the first time the majority of issuers were rated junk.

What’s more, this is the 23rd consecutive quarterly shift in the ratings mix from investment to speculative grade. Specifically, at the end of the second quarter, there were 1,572 investment-grade issuers and 1,618 speculative-grade issuers. However, the key force behind the shift has been new entries into the bond market, not downgrades, says S&P.

Through the first two quarters of this year, 70 percent of the 158 new entrants were rated B by the credit-rating agency. Furthermore, the median issuer rating for 2007 is expected to be BB, compared with BBB- at the end of 2006, BBB at the end of 1996, and A- 15 years ago, adds S&P. Otherwise, broad-based measures of credit-market performance — such as downgrade ratios, potential bond downgrades, and default rates — are still in relatively benign territory on a historical basis, points out Diane Vazza, head of S&P’s Global Fixed Income Research Group.

Even so, the near-term trend indicates that junk issues will likely outnumber investment-grade issues by a wider margin, given the ratings profile of the U.S. corporate bond market, the amount of leverage at the lowest-rated firms, current market demand and supply conditions, and the maturity of the credit cycle. “Indeed, the current ratings profile has heightened the risk in the U.S. corporate bond market,” adds Vazza.

Based on historical trends between 1981 and 2006, S&P reckons that 27 percent of CCC-and-below-rated firms — and 11 percent of B- firms — will default within a year. That also means the glut of firms at the B-rating levels pose significant default risk as well. In addition, as the economy and corporate profit growth slow, firms rated B and below will come under more pressure to meet their obligations, warns S&P.

This said, S&P’s near-term forecast predicts only a modest rise in the default rate, to 1.4 percent, by year-end — up from 1.22 percent at the end of June. “It would not be surprising to see even more new speculative-grade entrants this year, though firms may have to curtail leverage to clear the market,” says Vazza.

Only the financial, utility, and real estate sectors remain predominantly investment grade, with 86 percent, 80 percent, and 71 percent of S&P-rated entities staying out of junk territory, respectively. The media and leisure sector has the highest percentage of firms (85 percent) rated speculative grade, followed by the telecommunications (77 percent) and health-care (75 percent) sectors. The median rating is BB- for nonfinancial issuers and A for financial firms.

Understanding Which ERP Modules Your Business Needs – And When