Banc of America analysts see 2002 as nadir for U.S. credit quality

By Ronda Fears

Nashville, Dec. 19 - Banc of America Securities analysts believe that 2002 was the bottom of the cycle for U.S. credit quality, with several high-profile bankruptcies, so the credit outlook for investment-grade issuers is expected to improve in 2003 and there is optimism for high-yield credits.

"The problems that have plagued investment-grade issuers throughout 2002 are being resolved piecemeal, but small steps should add up to a big improvement in the credit outlook for 2003," the analysts said in a report Thursday.

"The high yield market managed to withstand one of its most turbulent years in recent history and will end 2002 in positive territory. While the year-to-date total return of 0.94% leaves much to be desired from this asset class, it exceeds the performance of other riskier asset classes such as convertibles and equities by a comfortable margin.

"After a roller coaster year in the high-yield market, it appears the market is heading up in 2003."

Chief authors of the report were David Goldman, head of global markets group research at Banc of America Securities, and Jeffrey Rosenberg, head of the global markets group credit strategy research. Raja Visweswaran, director of international credit research and Europe credit strategy also contributed to the report.

Quoted in the report were Ali Balali, senior high yield credit strategist at Banc of America Securities, and Eric Hiller, chief strategist on interest rates.

Seven of the 12 largest bankruptcies in the history of corporate America occurred in 2002, with a collective asset base of $275 billion, the analysts noted.

"The irresponsible management actions resulted in devastation for both equity holders and creditors this year. Head rolling in America's executive suite is associated with bankruptcy, which means clearing the ground for a fresh start," the analysts said.

Moreover the analysts said 2002 marked the nadir of the credit quality cycle in the U.S.

"The excesses of the late 1990s have been purged from the system, and management has refocused its attention on balance sheet reconstruction," the analysts said.

"Not long from now it will focus on reviving capital investment."

While it was up and down for the high-yield market in 2002, the analysts said that as default rates trend lower and recoveries show improvement they are positive for the 2003 outlook.

May was a decisive month for high yield, the analysts noted. After logging two consecutive months of strong gains in March and April, the market was pressured by a string of unfavorable corporate news in the telecom, media and entertainment, and utilities sectors.

The demise of WorldCom and Adelphia Communication was a severe blow, only to be followed by the revelation of "round-trip" trades by some utilities and power merchants.

Thus, May set the stage for a tough summer. The tone in the high-yield market improved markedly during the latter part of August, as capital outflows from the market subsided, but the strength was short-lived and in September the high-yield market gave back the August gains and then some.

By mid-October, the high-yield market was down 8.3% year-to-date, the analysts said.

Then "one of speculative-grade market's fastest recoveries in recent history" began.

"With default rates trending lower and recovery rates improving, we remain optimistic about the prospects for high yield during 2003," the analysts said.

"Based on our forecast for a decline in the default rate to a base case estimate of 7.4% and an increase in the average recovery on defaulted debt to 26 cents on the dollar, our estimate of loss given default decreases by 374bp to 5.5% from the end of 2001 levels.

"With no change in credit risk premiums, credit spreads should continue to tighten in 2003 reflecting the improving outlook for the economy and consequent decline in high yield investors' portfolio losses."

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