Capital Markets

Junk-Bond Rally Gets Junked

Early signs of high-yield recovery fade away, according to S&P.
Stephen TaubJune 26, 2008

The first signs of recovery in the junk bond market were cut short, as several measures indicated that high-yield securities are in worse shape than was thought, according to a new report from Standard & Poor’s.

The debt rating agency said that spreads on its high-yield composite index are currently at the 640-basis point level, which it says is more in line with default expectations of 4 percent to 6 percent for the year ahead. Meanwhile, the rate of downgrades has accelerated this year, with 186 downgrades through June 11 versus 151 in the second half of 2007. As a result, the trailing-12-month downgrade ratio — the percentage of downgrades to total rating actions during a 12-month period — climbed to 71 percent at the beginning of June, its highest level since March 2004.

S&P also said that forward-looking credit metrics based on outlook and CreditWatch status also project significant downgrade risk, with net negative bias at 23.46 percent. This indicator is now at its highest level since the end of 2003.

Meanwhile, the trailing-12 month speculative-grade default rate accelerated to 1.89 percent in May, with six US-based companies defaulting that month alone. S&P projects the trailing-12-month speculative-grade default rate to climb to 4.7 percent over the next 12 months.

These trends seem to be making issuers and investors a little jittery. According to S&P, deal flow May showed signs of life with $12.6 billion in new high-yield issuance. However, for the full year deal flow remains relatively weak. Through June 20, there has been approximately $25 billion in high-yield new debt issuance, well behind the $100 billion mark reached at the end of June in 2007 and $65 billion through the first half of 2006.

“The market usually enters a lull in the summer months, so we expect supply conditions to remain relatively tepid,” said Diane Vazza, head of Standard & Poor’s Global Fixed Income Research Group.

In a separate report, S&P noted that currently 749 issuers across all credit grades face potential downgrades, a new all-time high. This is 11 issuers more than 738 recorded last month. Potential downgrades are defined as entities that have either a negative outlook or ratings on CreditWatch with negative implications across rating categories ‘AAA’ to ‘B-‘.

“A material slowdown in housing and consumer-related activity and protracted tightening of lending conditions have continued to dampen credit fundamentals,” said Vazza.

The number of potential downgrades is 132 more than reported in the same period a year ago, when an upsurge of downgrade potential began as the material erosion of the residential real estate sector and large write-downs by financial institutions began, S&P said.

By sector, savings and loans recorded the highest ratio of issuers with a negative bias relative to their total rated universe, followed by mortgage institutions and forest products and building materials. “This is unsurprising given the weakness in the housing markets,” Vazza added. “Further, consumer discretionary sectors — including media and entertainment and consumer products — poised for deterioration because of a lessening of credit availability and weakening demand.”