S&P forecasts U.S. junk default rate to fall to 3.5% by March 2011

By Caroline Salls

Pittsburgh, May 4 - Standard & Poor's now expects its U.S. corporate speculative-grade default rate to dip below the long-term average to 3.5% in the 12 months ended in March 2011, according to a report released Tuesday.

The long-term average covering 1981 to 2009 was 4.5%.

The ratings agency also forecast alternative default rate scenarios for the year ended March 2011, with a 4.9% rate at the pessimistic end and a 3% rate at the optimistic end.

As previously reported, S&P's baseline forecast for year-end 2010 was 5%, with alternatives of 6.9% on the pessimistic end and 4.3% on the optimistic end.

As prices of high-yielding corporate bonds hurtle toward their par values, S&P said financial conditions for leveraged issuers appear favorable as of April.

In addition, the agency said the cost of funding in the bond market has dropped to its lowest level in 2.5 years, and distress-related indicators have been receding steadily, reflecting an increase in investor demand and, as a result, lower refinancing risk.

S&P said it does suspect that companies are frontloading some of the bond issuance in anticipation of higher benchmark interest rates later in the year. Nevertheless, it expects easy access to cash and the proliferation of bond-for-loan takeouts to lower corporate default risk in the near term, particularly for issuers that are able to opportunistically tap the bond market.

S&P said the future is cloudier for corporate buyers restricted to bank financing, but issuance is showing signs of revival even among these companies.

The agency said as many as 122 low-rated entities still remain vulnerable to refinancing risk in the United States and are concentrated in consumer-oriented sectors.

S&P said it believes residual default risk beyond the one-year forecast horizon could increase because of the significant overhang of surviving leveraged corporate issuers.

Red flags

The agency said the substantial decline in risk premiums for lower-rated borrowers and the return of what it views as questionable practices and structures in some recent deals, including raising bond funds to pay out shareholder dividends or sponsors, further "raise flags that the optimism might be overdone."

"In the slim chance that the economy experiences a double-dip recession, many of the surviving leveraged issuers originated during 2003-2007 could face renewed default risk unless they significantly reduce their debt burdens," S&P said in the report.

"Thanks to a wave of refinancing, corporate issuers may have engineered lower default expectations in the near term, but this does not mean that their default risk has been permanently expunged.

"Rather, we believe that the current vigor in the leveraged finance markets has enabled some highly leveraged corporations to extend maturities and lower refinancing costs and net debt, thereby likely staving off default."

S&P said much of the rush to amend and extend maturities or implement bond-for-loan takeouts likely will occur in the first half of the year as issuers anticipate a narrowing window of opportunity based on higher year-end interest rate expectations.

However, S&P said the risk remains that unless leveraged borrowers use the breathing room to position themselves on a more conservative financial path, they could continue to experience higher-than-average default rates in the years beyond the forecast horizon.

"In the absence of higher top-line growth and lower leverage, some of these companies might continue to suffer because of limited financial flexibility, disappointing bondholders and other primary investors as other stronger companies successfully navigate to a better outcome," S&P reported.

S&P said it updates its outlook for the issuer-based U.S. corporate speculative-grade default rate each quarter after analyzing the latest economic results and expectations.

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