Capital Markets

S&P, Investors Issue Junk Warnings

The default rate on speculative-grade bonds remains low for now but is primed for a sharp upturn.
Stephen TaubJanuary 25, 2008

The global speculative-grade bond default rate finished 2007 at a very low 0.86 percent, according to Standard & Poor’s. In the United States, the default rate fell to a 25-year low of 0.97 percent.

But it could be the calm before the storm. Junk-bond issuers are facing some imminent challenges from the standpoints of both credit quality and demand. S&P forecasts that the U.S. default rate will more than triple, to 3.4 percent, by the end of December. That is still lower, though, than the 4.4 percent historical average.

The proportion of low-rated bond issuance (the number of deals rated B- or lower as a percentage of total speculative-grade offerings) increased to 49.2 percent at the end of 2007 compared with 42.5 percent in 2006.

“We expect the U.S. speculative-grade default rate trajectory to escalate in the next several quarters based on the cumulative impact of the changes in the credit-pricing environment, an increase in refunding needs, and a slowing economy,” said S&P in a new report. “Rising volatility in the credit markets and escalating risk of recession contribute to substantial variability around the default forecast.”

In fact, the debt-rating firm said the Federal Reserve’s recent surprise move to cut interest rates by 75 basis points indicates the accelerating risk of recession.

Investors seem to be concerned as well. A Reuters report noted that U.S. junk-bond mutual funds reported $232 million in net outflows in the week ended Wednesday. This marked the sixth straight week of net outflows from the funds.

No doubt investors are mindful that so far this year, junk bonds have recorded a loss of 2.46 percent, the worst performance among major classes of U.S. bonds, according to Reuters, citing Merrill Lynch data. And last year, junk-bond mutual funds returned 1.5 percent on average, making it the second-worst-performing category among fixed-income funds, according to Morningstar.

S&P also expects the default rate to increase in the leveraged-loan segment as the slowing economy and a less-liquid environment increasingly strain already vulnerable sectors and highly leveraged issuers. In fact, the loan distress ratio — defined as the percentage of performing loans trading below 80 cents on the dollar — already has started to increase, recording a 44-month high of 3.23 percent in December, from 2.40 percent in November and 0.10 percent at the beginning of 2007.

Little surprise, then, that mutual funds that buy bank loans were the worst performers among fixed-income groups in 2007, according to Bloomberg.