Outlook 2007: Fitch, S&P, Moody's forecast record-low default rates will not last through end of 2007

By Jennifer Lanning Drey

Portland, Ore., Dec. 29 - Fitch Ratings, Standard & Poor's and Moody's Investors Service all predicted that 2007's speculative-grade default rates will rise above 2006's extraordinarily low ending numbers; however, all three agencies also projected that rates will remain below the long-term average through the end of the new year.

S&P predicted that the U.S. speculative-grade default rate will be between 2.5% and 3% by the end of 2007, while Moody's also put it at 2.5%. Fitch did not generate a percentage estimate but agreed that the default rate is likely to rise.

Fitch: consumer spending top factor

Fitch forecasted that the U.S. high-yield default rate will increase from roughly 1% at the end of 2006 but continue to remain below average in 2007, with consumer spending being the most important contributor to the rate in the upcoming year, according to Mariarosa Verde, Fitch's managing director of credit market research.

"It is practically a given that default rates will move up in 2007," Verde said, citing a slowdown in economic growth and the substantial volume of outstanding bonds rated CCC or lower as indictors that the default rate will inevitably rise.

The U.S. high-yield market contains $125 billion in bonds carrying ratings of CCC or lower, according to Fitch research generated in late November.

"High-yield companies enjoyed boom times in 2006 - it was definitely a borrower's market all around with highly favorable terms and spreads in both the bond and loan markets," Verde said.

While the strong economy and credit availability have depressed default rates for low-rated issues in the past, Verde believes credit availability is "nothing more than a by-product of expectations for economic growth."

Therefore, the most important factor in setting the default rate environment in 2007 will be the economy, and in particular, how well consumer spending holds up given the housing slowdown, she said.

Based on the agency's expectations that consumer spending will soften in the first half of 2007, Verde said the default rate is more likely to accelerate in the second half of the year.

Accordingly, sectors exposed to discretionary consumer spending will be among those most at risk of default in 2007, she said.

Fitch credit market research released in late November also showed that industrial issuers in North America and Europe are likely to have difficult times in the new year, as the sector experienced more ratings downgrades than upgrades in 2006 - a trend that is expected to continue in 2007.

Global banking and finance companies are expected to show strength in 2007, as upgrades in the sector exceeded downgrades by 4 to 1 in the first nine months of 2006.

Overall, Fitch's global corporate finance downgrades have trailed upgrades quarter over quarter, resulting in a ratio of downgrades to upgrades of 0.5 to 1 for the three-quarter period ended in September.

Fitch plans to introduce a formal default-forecasting model in 2007 but currently bases its default rate projections on factors including GDP growth, interest rates, credit availability, new issuance quality and upgrade/downgrade trends.

S&P: 'turning point' in credit quality

S&P also expected the credit cycle to transition toward more normal conditions in 2007, with the U.S. speculative-grade default rate rising to somewhere between 2.5% and 3.0% by the end of 2007 from an all-time low of 1.6% in mid-December.

In its December "U.S. High Yield Prospects" report, the agency said that while a surplus of liquidity, low interest rate volatility and strong profits have the U.S. high yield market riding a strong wave, credit quality is "peaking and heading for a turning point."

In 2007, S&P forecasts the high-yield market will experience increased downgrade and default risks - a prediction based in part on the agency's expectation that average real GDP growth will have difficulty crossing the 2.5% mark in 2007 and 2008.

The current "virtuous" credit cycle dynamic, which has helped reduce risk aversion, is unlikely to withstand a prolonged, macroeconomic slowdown, the agency said in the report.

Additionally, in a separate December report, S&P said that a continued high proportion of bonds issued at the B- rating or lower beginning in 2003 also serves as an early warning of renewed default pressure.

In mid-December, issuers rated CCC+ and below had brought $6.8 billion more to the market than in 2005, according to the agency, which also reported that during 2006, issuers rated B- or lower had incurred $39 billion of debt.

Just before year-end, the agency predicted that the U.S. speculative-grade default rate would end 2006 at 1.2% and then begin edging up over the next eight quarters.

Firms in the health care and automotive sectors showed the highest propensity for distress, followed by retail and restaurants. The media and entertainment and consumer product industries are also susceptible to defaults in the future, the agency said.

Among the more risky sectors, S&P expects the highest recovery rates to come from defaults in the media and entertainment, consumer products and retail and restaurant industries.

S&P also forecasted that default rates among U.S. leveraged loans will increase to 2.61% by November 2007 from 1.15% in November 2006 as the increasingly aggressive structures of the new issue market will leave many issuers vulnerable to default when liquidity dries up.

Moody's sees rise but no sharp upturn

Moody's also projected that the credit cycle will begin to change in 2007 and forecasted that the global speculative-grade default rate will rise to 2.5% by the end of November 2007 from 1.8% at the end of 2006.

"The results of Moody's latest forecast hold both good and bad news for high-yield investors," said David Hamilton, Moody's director of corporate default research in New York, in a December news release.

On the positive side, the predicted global default rate does not appear to be set for a sharp upturn and is still only roughly half of the long-term annual average rate since 1980, Hamilton said in the release.

However, it appears that default rates may be near the bottom in this credit cycle, he also said.

Moody's reported that at 2.0%, the U.S. speculative-grade default rate at the end of November was slightly down from the year's opening level of 2.3%.

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