right now it's hard to see the 'hard landing' scenario, but if it happens....)
ibtimes.com
Junk Bonds Riskier Even As Defaults Fall
Posted 11 January 2007 @ 12:38 pm EST
NEW YORK (AP) - Abetted by seemingly benign default rates, investors continue to dive into a swelling pool of the riskiest junk bonds despite receiving less return than ever before.
This has created a paradoxical and largely unprecedented scenario in which default rates continue to fall even as the high-yield bond market as a whole, as measured by ratings, is becoming increasingly risky, all while premiums have reached all-time lows.
With many predicting an economic slowdown and a rising default rate in 2007, some analysts reckon investors in the riskiest junk bonds could be in over their heads, exposing themselves to potentially big losses when the companies that issue these bonds start running into trouble.
"It bodes very bad if we have a hard landing," said Martin Fridson, publisher of the Leverage World research service. "Given today's ratings mix we could have default rates that would make even the 'Great Debacle' of 1989-1991 (when default rates reached 12.8 percent) pale by comparison." He added that even a softer landing could still produce default rates in the high single digits.
To be sure, few are predicting a hard landing for a decelerating economy is on the cards, but the increased proportion of highly speculative bonds in the overall high-yield bond market leaves investors more vulnerable when the credit cycle turns.
Bonds assigned a CCC rating by the three major rating agencies now constitute approximately 15.8 percent of all junk bonds, according to the Merrill Lynch High-Yield Master II Index. Since 1996, the percentage of CCCs has ranged between 5.9 percent and 17.5 percent.
This movement toward increased risk is happening as investors increasingly are emboldened by historically low junk-bond default rates. Fitch Ratings measured the U.S. high-yield default rate at an all-time low of 0.8 percent in 2006, down from 3.1 percent in 2005 and well below the long-term average of around 5 percent. According to Moody's Investors Service, the global speculative-grade corporate bond issuer default rate fell to 1.7 percent in 2006 from 1.9 percent in 2005, the fifth consecutive annual decline.
Issuers rated CCC or lower typically default at an average annual rate of 25 percent, as measured by Fitch. In 2006, the default rate for such issuers was 4.5 percent, the lowest in 20 years.
What makes the situation even more unusual, and potentially perilous, is that risk premiums for highly speculative bonds have fallen to record lows. The index of CCC-rated bonds recorded a spread level of 5.53 percentage points over 10-year Treasurys at the end of 2006, according to Merrill Lynch, marking the lowest-ever reading in the 18-year history of that measure. That is well below the historical average of 11.20 percentage points over Treasurys and the all-time high spread of 21.77 percentage points over Treasurys in Sept. 2002.
The current relationship between the default rate and the amount of highly speculative debt runs counter to both logic and history, according to Fridson. He cited data showing that the relative market weighting of CCC-rated debt has tended to track the default rate over time. He said that this makes sense, as downgrades from higher ratings would tend to swell the CCC segment at times when credit risk, and hence the default rate, are rising. The opposite should also be true, as times of easing credit risk, indicated now by low default rates, should mean more upgrading of companies.
Instead, Fridson said, the current credit cycle has seen a growing divergence between the relative weighting of CCC bonds and the default rate over the past five years, which could prove problematic in the event of an economic downturn. In fact, Fridson noted the percentage of CCCs could balloon even further since the conventional cause for downgrades - cyclical pressure on earnings - has yet to kick in.
According to Fitch, the combination of a large volume of new CCC-rated bonds with a historically low default rate suggests that the high level of liquidity in the markets, rather than company fundamentals, has been responsible for keeping defaults in check.
"Because these deep speculative grade companies usually operate with a very low margin for error, they really need access to capital in order to stay afloat, often even to simply service their existing debt," said Mariarosa Verde, managing director of credit market research at Fitch. "I think there is a greater risk going into 2007 that a shock or a drying up of liquidity could cause a spike in the default rate."
Verde said that "the stars aligned" for the high-yield market in 2006, calling it the best funding environment ever for risky companies with ample access to the loan and bond markets due to an unprecedented inflow of nontraditional money into high yield. She said that the environment for such issuers will likely become more challenging in 2007, citing the most recent Federal Reserve Senior Loan Officer Survey that showed a retreat in bankers' receptivity to risk in the second half of 2006. |
