Outlook 2005: Experts foresee slight increase in defaults

By Jeff Pines

Washington, Dec. 31 - Expect a small increase in defaults among high-yield issuers in the coming year. That's the consensus of analysts at Moody's Investors Service, Fitch Ratings and Standard & Poor's Ratings Services.

Moody's model forecasts default rates to initially decline to a low of 1.9% in March and then to start moving up to end 2005 with a rate of about 2.6%, said David Hamilton, director of corporate default research at Moody's.

Hamilton and Moody's rely on a forecasting model using macroeconomic factors such as industrial production, the slope of the Treasury yield curve, interest rates and the change of distribution of credit issuers.

"We've been using it since 1998 and it's been really good at predicting turning points," he said. "We're pretty confident that's going to be the case."

While Moody's forecast does call for an increase to a 2.6% rate, Hamilton noted that a 2.6% default rate is still below average and the level is not expected to bounce higher after the low point.

"The long run default rate between 1983 and 2003 is 5%. There are some red signals starting to flash," he said.

An indicator that the market is either past the peak of declining default rates or nearing the peak is the rising percentage of new issuers with speculative ratings. The percentage of new issuers with speculative ratings below B is about 30%. "So about a third are extremely low credit quality," Hamilton said.

A possible cause for concern would be if a lot of Caa rated issuers default. Then defaults might start creeping up into the next highest bracket, but at this point Hamilton does not see any signs of defaults creeping up to a better credit grade.

Fitch worries over readiness to lend

At Fitch, Mariarosa Verde, a managing director, forecasts defaults will continue to remain below average but will likely increase from the current low level to somewhere above 2%.

Fitch's economist is projecting slower growth in gross domestic product and another adverse factor she sees is rising interest rates creating more yield alternatives for investors.

"It's not clear the market will be as ready to lend money to the high-yield market," Verde said.

"In the high-yield market, the sector is very sensitive to macroeconomic conditions and credit availability. When economic growth is sluggish, high-yield defaults are typically above average, and when the economy is booming, high-yield defaults drop to very low levels," she said.

Even with GDP growth of 3.5%, that's very healthy growth, and a healthy economy will enable some high-yield issuers to improve their credit profile, lowering their leverage, Verde explained.

S&P sees rise

At S&P, Diane Vazza sees a slight rise from the third-quarter default rate of 2.3%. The rate should rise to an average of 2.6% for 2005, much lower than the 4% historical average for the last four quarters. As of Dec. 8, S&P reported there were 26 issuers rated CCC or lower that could default on rated debt of $6.6 billion, according to her weakest links and monthly default rate report.

Of those 26, 20 are U.S. companies. The other six are issuers from Argentina, Brazil, Canada, the Dominican Republic, Norway and Sweden.

She adds that there are signs the manufacturing sector is making a comeback with growth in industrial production for 14 straight months in the United States. Across the Atlantic, the European Union's industrial production has been growing for 12 straight months until September.

Looking past 2005

Beyond 2005, Verde and her team at Fitch are looking ahead to 2006 and 2007 because many high-yield issuers have refinanced to get lower interest rates, but the bond maturities have been pushed out to 2006 to 2008. Taken together, in 2006 and 2007, Verde estimates that $71 billion of bonds, or about 10% of the U.S. high-yield market, are set to mature over these years. "So the ability to refinance in those two years may be critical," she said.

Verde warns that if the economy staggers some of the companies that will have to roll over their debt from 2006 to 2008 may have a problem refinancing.

Vazza said speculative-grade defaults could peak in two to three years because more than 30% of the speculative-grade issuers coming to market for the last five quarters in the United States and last four quarters in Europe have been rated B- or lower.

"It may be a good idea for investors to look at spreads. Right now spreads are really tight and they may start to loosen," Fitch's Verde said.

What industries should investors keep an eye on in the coming year that may be more default prone than others? Analysts suggest keeping an eye on transportation, metals and mining, hotels and casinos, telecommunications and media, and health care.

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