Credit cycle set for turning point, Moody's says

Corporate debt defaults packed a deceptively hard punch in 2005, despite their relatively small number, according to research from one of the world’s largest debt rating agencies. Fixed income investors can expect more defaults among speculative-grade bonds by year end.

“It depends who you ask whether 2005 was a good year or not,” says David Hamilton, director of corporate default research at Moody’s Investors Service. “Looking only at the numbers, one would come away with the conclusion that it was a fairly benign year. On the other hand the volume of defaults increased.”

Speaking to a lunchtime meeting of the Toronto CFA Society on Tuesday, Hamilton said the default rate for all rated issuers was only 0.6% in 2005, down from an already low 0.8% in 2004. Among Moody’s-rated companies, there were just 32 defaults.

But while the number of corporate debt defaults appeared low in 2005, the dollar value was so large that a much greater impact was felt among investors. The value of defaults from these few companies totaled $29 billion US.

In Canada, there were no defaults in 2005 among the companies rated by Moody’s, but there were two unrated defaults “of a small size,” Hamilton says. Since 1989, there have only been 66 defaults among rated Canadian firms.

Defaults were concentrated in a handful of industries, with independent power, communications, transportation and auto parts making up the lion’s share of defaults, by value. Investors will recognize names like Calpine, Charter Communications and Delta Airlines. These companies defaulted on $19 billion worth of debt alone, accounting for more than 65% of defaults.

“We have very concentrated pockets of credit risk. The question going forward is will it persist?” Hamilton said. “When the credit cycle turns, you’ll see a broader cross-section of defaults across industry categories.”

So while the default rate fell in terms of issuers, the value of defaults climbed from 0.5% of the corporate universe, to 0.8%.

As the name suggests, speculative-grade debt is most susceptible to default. The default rate for these bonds also fell, to 1.9% from 2.4% the year earlier. That’s well below the historic average of 5.1%, but Hamilton says the Moody’s model projects a rise to 3.3% by the end of this year.

While there are a number of factors weighed in the Moody’s projection, one of the key reasons for increasing defaults is the “seasoning effect.” Historically, low-quality debt issuers tend to default in their third or fourth year after issuance.

Often small start-ups seeking a great leap forward, new issuers can burn through the capital they raised through debt within the first two years. If they have not executed their growth strategy, these firms can find themselves in default in the third or fourth year.

Hamilton says there was a flood of low-quality bonds issued in 2003 and one third of speculative-grade issuance rated Caa in 2004. Inevitably, a certain percentage of these low-grade bonds will “season” into defaults starting in 2006 and running through 2008.

It is unclear whether defaults among the Caa-rated bonds will spill over into the B-rated, Baa-rated or beyond. Even after factoring in shocks of up to 50% to their model, Moody’s sees the default rate only reaching 4.9% by year’s end.

Hamilton sees no reason to panic, saying the current trend appears to be just a typical turning point in a normal credit cycle, with no apparent catalysts present to cause a shock. He does not expect a return to the double-digit default rate of 2001 and points out that in there have only been three such periods since the early twentieth century: 1929, 1991 and 2000-2001.

While those date instantly cause alarm, Hamilton points out that each of these periods had identifiable catalysts, such as deregulation or technological and financial innovation. He admits that credit derivatives could prove to be such a catalyst, but says there is no way to such an event in advance. And while one may be tempted to assume that high default rates cause recessions, or vice versa, he says neither influences the other, but are both the result of some other catalyst, which may cause one, the other or both.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(03/01/06)

Steven Lamb

Share

Steven Lamb

FAIR Canada applauds Saskatchewan’s OBSI bill

Private equity firm buys maker of hockey rink boards

Scotiabank profits slip amid rising strain in auto loans, mortgages