Outlook 2008: Fitch, Moody's, S&P forecast tougher access to credit; high-yield default rate to rise

By Jennifer Lanning Drey

Portland, Ore., Dec. 31 - Fitch Ratings, Moody's Investors Service and Standard & Poor's all expect the global speculative-grade default rate to end 2008 significantly higher than the area around 1% where it hovered in late 2007.

Fitch projected the highest increase, estimating that the rate would end the year in the mid-single digits, bringing it much closer to 5%, which the agency considers to be the long-term average annual default rate. Moody's placed the global speculative-grade default rate at 4.2% by the end of 2008, while S&P projected the rate would jump to 3.4% by November 2008.

At the start of 2007, each of the agencies projected similar jumps in the default rate, which never materialized, as economic growth remained strong and credit conditions continued to be borrower friendly through the first half of the year.

However, a repeat performance is very unlikely in 2008, as the problems that have surfaced since the summer of 2007 are far more serious than anything that was on the horizon in early 2007 when the agencies made those projections, Mariarosa Verde, Fitch Ratings managing director of Fitch Credit Market Research, told Prospect News in December.

In particular, the possibility of a recession was not in the picture, she said.

Fitch: credit availability top factor

Fitch Ratings forecasted the U.S high-yield default rate will show a meaningful increase in 2008, rising to somewhere between 4% and 5% by the end of the year.

While the agency believes there are a number of factors that will contribute to the significant jump from 2007's projected year-end rate of less than 1%, the most significant cause is likely to be credit availability, according to Verde.

"While it's absolutely true that strong corporate performance has been a major factor behind the below average default rates we have experienced over the past several years, the other important driver has been credit availability," Verde said.

Of course, with the current housing industry downturn and possibility of a recession, banks are tightening access to credit. At the same time, spreads have widened, the stock market experiences wild price swings on a regular basis and the Fed has had to step in to cut rates - all of which suggest that 2008 will be a very different year in terms of credit availability, Verde said.

Fitch also expects the economic conditions of 2008 to contribute to the projected increase in the default rate. With GDP growth expected to run below 2% in 2008, the most levered borrowers will have difficulty servicing their debt and will not have generous investors and lenders ready to back them up.

"Unfortunately, what tends to happen in high yield is that credit availability magnifies the economic effect both on the upside and on the downside. When times are good, access to credit further depresses default rates - beyond even what fundamentals might suggest," Verde said.

"When the environment turns, borrowers lose on both ends."

However, whether the increase in defaults among the most levered borrowers becomes widespread will depend on the extent to which the economy slows and how long the slowdown lasts, she said.

Moody's: spreads, market to spur increase

Moody's also said increased credit spreads, changes in the credit markets and a less lively economy make it certain that the global speculative-grade default rate will rise in the new year. In December 2007, the agency predicted the rate would climb to 4.2% by the end of 2008.

Moody's 2008 projection assumes a 4.7% default rate among U.S. speculative-grade issuers and 3.0% among European issuers by November 2008.

"Time is running out for many issuers with unsustainable negative cash flow," said Daniel Gates, Moody's chief credit officer for corporate finance.

Such issuers will eventually violate covenants, reach a debt maturity or be forced to seek a restructuring because they lack sufficient cash for operating and capital-spending needs.

Up to now, the currently low default rates reflect the easy credit conditions of the past couple of years, which allowed most issuers to refinance on favorable terms, and strong economic growth, which allowed issuers to make their debt service payments, Moody's said in a December report.

However, a default pipeline is slowly building for companies that increased their debt during the period of easier credit availability, and some of these lower-rated companies are now reporting weaker-than-expected results, which are pushing them toward covenant defaults, according to Gates.

Prospects for refinancing are poor for such companies, and lenders are reluctant to waive covenants in credit facilities that are priced and structured well below the market's recalibrated standards, he said.

"Lenders will assess whether recovery will be greater if management is given more time to work out the company's problems or if it is more advantageous to push the borrower into bankruptcy to limit further erosion of value," Gates said.

He believes low-rated companies that need to go to the market to obtain new financing in 2008 are likely to find access to credit to be sporadic. There may be a crowding-out effect for speculative-grade issuers since underwriters may still be trying to market older leveraged buyout commitments in the first quarter of 2008, he said.

At the same time, however, Moody's pointed out that the increasingly negative trend for credit quality among North American issuers is far less severe than before the last sharp upturn in default rates, in the 2000 to 2002 timeframe.

Still, rating downgrades have exceeded upgrades throughout 2007, with the pace picking up in the fourth quarter.

In addition, Moody's speculative-grade corporate distress index, which measurers the percentage of rated issuers that have debt trading at distressed levels, jumped to more than 10% in November - its highest level in almost five years.

S&P: Upward trend

S&P projected that the global speculative-grade default rate will jump to 3.4% by November 2008 - and continue in an upward trend from there - as changes in the credit-pricing environment, an increase in refunding needs and a slowing economy push companies that have been able to hold on in 2007 into default in 2008.

"Financial strategies implemented during the favorable credit environment of recent years have insulated even the most vulnerable entities, allowing them to continue meeting financial obligations and forestall payment default despite the more challenging credit landscape, S&P said in a mid-December monthly default rate report.

The agency said those factors might continue to help companies in the first half of 2008, potentially suppressing defaults even as broad macroeconomic performance weakens.

However, conditions in late 2007 suggest that the tide will turn for high-yield corporates at some point during the year.

In 2008, corporate borrowers may look to refinance as much as $251 billion, based on the maturity schedules of all of S&P's U.S. rated fixed- and floating-rate bonds, according to the agency. Like the other ratings agencies, S&P said access to credit is unlikely to be as plentiful as it has been in the recent past.

High-yield cash spreads exceeded 500 bps in the middle of November for the first time since November 2004. At the same time, the high-yield distressed ratio continued on an upward trend through the end of 2007, jumping to 6.1% in December, up 4.9% in November and up from 2.3% in October, according to agency data.

Additionally in late 2007, S&P said ratings appeared poised for vulnerability, in light of the ongoing volatility in the credit markets. In the third quarter, the downgrade-to-upgrade ratio rose to 1.14% after 12 quarters at 1.00% or below. Much of the increase stemmed from a sharp drop-off in upgrades relative to prior quarters, according an S&P quarterly default update report.

In mid-December, S&P said that globally, the downgrade risk continues to remain elevated, after the number of entities at risk of downgrades steadily increased to 662 in December, which is 27 more than the average reported in the past 12 months.

The elevated high-yield cash spreads seen in late 2007 also suggest that in addition to the agencies, investors expect to see higher default rates and a slower earnings environment in 2008, the agency said.

The leading sectors at risk of downgrade included consumer products, media and entertainment, retail/restaurants and the automotive sectors, according to S&P.

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