Global default rates inched up slightly to 5.41% at the end of October, compared with a revised rate of 5.35% a month ago, however, the current rate continues to hover above the long-term (1981-present) average of 5.17%, a report released from Standard & Poor’s Ratings Services claims.
The decline in the speculative-grade default rate has been accompanied by an easing of lending conditions, as reported in recent surveys conducted by the US Federal Reserve and the European Central Bank. Falling default rates are among the factors that have facilitated spread compression, thereby enhancing issuance conditions in the speculative-grade bond markets-on both sides of the Atlantic-even though they are still at odds with the current trends in the industrial sector, a testimony to the fact that the manufacturing sector remains a laggard in this current gradual recovery cycle.
For instance, industrial production-generally regarded as a fairly good leading indicator of the speculative-grade default rate-remained in negative territory in the US for the sixth consecutive month (in September) and below zero in Europe (in August) despite having crossed the threshold a month earlier. Data on orders-nondurable and durable-indicate that strength in manufacturing is rebuilding gradually.
“Evidence that economic strength is being rebuilt and corporate profitability is improving implies a more sanguine outlook for defaults in the near term,” Diane Vazza, head of Standard & Poor’s Global Fixed Income Research group, says. “Still, at least in the US, the rising proportion of lower-grade issuance (‘B-‘ or lower) serves as an early warning of renewed default pressure two-three years ahead.”
On a 12-month rolling basis, a global speculative-grade default rate of 5.41% was reported at the end of October, compared with 6.27% six months ago. The US recorded a speculative-grade default rate of 6.15%, lower than the 6.21% recorded in April. European speculative-grade default rates displayed a more dramatic drop to 4.43% at the end of October vs 10.42% six months ago. Declines were also observed in the emerging markets, which recorded default rates of 3.86% in the most recent month vs 5.09% in the corresponding period. This slide in default rates has been accompanied by an easing of credit standards in both the US and Europe.
A total of 110 defaults have been recorded in the year to date on rated debt outstanding worth US$50.4bn. Of the total, 85 defaults were recorded in the US on rated debt worth US$37.8bn. As of November 4, a total of 38 entities still remained vulnerable to default. These “weakest link” issuers are defined as issuers that carry a credit rating of ‘CCC’ or lower and are listed either with a Negative Outlook or a CreditWatch with negative implications.2 The current list of 38 is one less than the number reported a month earlier. Of the 39 reported in October, one issuer defaulted; one issuer is no longer rated; and another issuer had its Outlook status upgraded. Meanwhile, two new issuers were added to the list.
By sector, telecoms and media and entertainment continued to show the highest vulnerability for default among the “weakest links”. Of the 38 issuers on the most recent list, seven were from telecoms and six from media and entertainment. The two sectors together accounted for 34.2% of the total. This concentration is in part the outcome of a heavy spate of issuance in 1997-99 at the lower rungs of the rating spectrum (‘B-‘ and below).
Geographically, US-based issuers featured disproportionately on the “weakest links” list, accounting for 33 of 38 issuers. This preponderance is attributable to the higher ratings penetration in the U.S. marketplace. Elsewhere, one issuer each from Mexico, Argentina, Brazil, Norway and the UK featured among the “weakest links”.
In the U.S., the share of new issue volume by issuers rated ‘B-‘ and lower has been steadily increasing as a proportion of total speculative-grade issuance this year (see chart 3). Most recently, this share increased to 33% in the third quarter from 28% in the second, and 26% in the first. Issuance generated at the ‘B-‘ level and lower on the rating spectrum is typically a breeding ground for potential defaults. The previous spike in low-grade issuance at these rating categories during 1997-99 subsequently led to a peak in defaults in 2001. During this period, the share of speculative-grade companies with issuance rated ‘B-‘ or lower consistently exceeded 30%.
“If the current proportion remains above the 30% range for a sustained period of time, it will serve as an early warning that the speculative-grade default rate could worsen in three years, which is typically the length of time between elevated issuance and higher defaults,” Vazza concludes.