Outlook 2009: High-yield default rate likely to hit double digits by end of 2009, ratings agencies say

By Jennifer Lanning Drey

Portland Ore., Dec. 31 - The U.S. speculative-grade default rate is likely to soar to double digits by the end of 2009, increasing rapidly from the rates expected at the close of 2008, Fitch Ratings and Moody's Investors Service told Prospect News in mid-December.

Standard & Poor's expected the speculative-grade default rate to jump to 7.6% in the United States by the end of September 2009, as compared to 3.2% in November 2008 and 0.97% at the close of 2007.

"When the default rate turns, it can turn very rapidly," Kenneth Emery, director of corporate default research for Moody's, told Prospect News in December.

In that way, the projected increases in the default rate for 2009 reflect a similar pattern to those seen in the other two downturns that have occurred since the birth of the high-yield markets.

However, the current downturn - now officially a full-blown recession - also encompasses a number of factors that didn't play into the sharp default rate curves of the past.

In particular, high-yield spreads have exceeded 2,000 basis points, whereas in the 1990/1991 and 2000/2001 cycles it never went above 1,000 bps, Emery said.

Additionally, the current downturn is ridden with deal structures created and carried out in the 2004 through 2007 timeframe, many of which are characterized by longer-dated maturities, covenant-lite loans and payment-in-kind toggle features.

On top of that, there seems to be a higher degree of uncertainty surrounding how long the tight credit conditions will last, when real estate values will stabilize and the global scope of the downturn, Emery said.

Accordingly, any default rate projections made in such an environment warrant a note of caution, he said.

Fitch: record defaults possible

Fitch projected the U.S. speculative-grade default rate would be close to 5% at the end of 2008 and continue to rise in 2009, most likely reaching double digits by the end of the year.

"We continue to worry that we will see new default records over the next several years," Mariarosa Verde, managing director of Fitch credit market research, told Prospect News in mid-December.

The path that the default rate will ultimately take in 2009 will be affected by a number of factors, but the most important issue will be the health of the broader economy because it sets the tone for the second most important factor - credit availability, Verde said.

That said, Fitch believes the world economy is facing a severe recession and projects a GDP of negative 1.2% for 2009.

Fitch's concern that default rates will hit record levels also considers the unprecedented number of negative events that occurred in the past year, which have resulted in excessive risk aversion.

Additionally pressure on consumer spending and the record number of deeply speculative-grade borrowers means many vulnerable companies will be trying to survive in a very difficult environment, she said.

"Many, if not most, will need to restructure because the macro picture both from an economic and funding point of view is very much working against them," Verde said.

Even those who can get financing may not be saved.

"Conditions are such that you are lucky if you can borrow, but even having access to capital is not a panacea because the cost of debt for speculative-grade entities has exploded over the past year and this at the same time that profits are shrinking," Verde said.

Additionally, she said the loose borrowing conditions in 2005, 2006 and early 2007 appear to have depressed defaults as many companies pushed out their bond and loan maturities, while negotiating favorable terms such as loose covenants.

Of course, sooner or later these companies will run out of cash and not be able to service their debt, she said.

S&P sees default vulnerability

S&P's managing director and head of global fixed-income research, Diane Vazza, said the lack of access to the credit and capital markets is hitting highly leveraged low-rated companies particularly hard.

"Those companies are vulnerable," she said in mid-December.

Vazza noted that the default rate has been consecutively ticking up since reaching a record low of 0.97% in December 2007.

"Within global corporates, the increasing proportion of speculative-grade ratings seems to finally be bringing the default rate upward," S&P said in its Quarterly Default Update & Ratings Transitions report released in October.

S&P's baseline forecast is for a 12-month forward speculative-grade default rate of 7.6% in the United States by September 2009, which is substantially higher than the long-term average of 4.4%. The baseline forecast has a 60% probability, according to the agency.

To realize the projection, 125 issuers would have to default in the period from September 2008 to September 2009, which implies an average of 10.4 defaults per month.

There were 16 total defaults in the United States in 2007.

The agency also noted that many factors could contribute to substantial variability. Accordingly, it also generated a pessimistic projection of 9.6% and an optimistic scenario of 6.1%, both with 20% probability.

Either way, S&P said in the report that stepped-up origination activity at ratings of B- or lower between 2004 and 2008 signifies pent-up accumulation of default vulnerability.

Vazza said S&P predicts defaults will peak nine to 12 months before the end of the recession.

"Defaults will ramp up into the end of 2009 and 2010," she said.

Moody's: flood gates to open in 2009

Moody's also believes the ongoing credit crisis will leave few options for companies needing to refinance maturing debt or amend loan agreements in 2009, Emery said.

In its November Default Report, the agency said it expects the default flood gates to open in 2009, pushing the global speculative-grade default rate to 10.4% by December 2009, compared to 4.2% at the end of 2008. The projection implies roughly 225 defaulters in the next 12 months.

The U.S. rate of default is expected to be 10.7% in December 2009.

The rate of the projected increase is similar to the 1990/1991 downturn in which the global speculative-grade default rate jumped to 12% in July 1991 from 2.5% in June 1989.

In that downturn, the default rate also moved rapidly when it began to turn around. However, this time may be different, Emery said.

"Everyone agrees that the underlying factors in this downturn are different from the '90/'91 and 2000 cycles," he said.

Regarding the current cycle, Moody's expects a growing share of near-term defaults to be distressed debt exchanges as the debt markets remain closed to speculative-grade issuers, and the scarcity of debtor-in-possession financing makes bankruptcy an unattractive option, the agency said in the report.

Forced bankruptcies

At the same time, many defaulters will end up in bankruptcy court in 2009 as creditors show an unwillingness to work with companies in the current economic environment, Sam Rovit, managing partner for Bain CRG, a turnaround services provider, said in a mid-December interview.

"Creditors are focused on their own balance sheets. They want out of problems," he said.

The result is that some well-run companies will end up in bankruptcy.

That's different from downturns of the past when creditors may have been more willing to work with troubled companies, he said.

Chaotic free-fall

Once forced into bankruptcy, the process may not be as smooth as it once was when DIP funding was easier to come by, Rovit said.

Without adequate DIP funding, a company in bankruptcy can rapidly succumb to a chaotic free fall, or more specifically, a disorderly unwinding of assets.

Even companies given the opportunity to sell their assets in an orderly manner are likely to face difficulties given the current credit environment, Rovit said.

"How can you sell off assets if all the logical buyers are in trouble and have no credit?" he said. "The standard restructuring playbook is very difficult to execute in this environment."

The result is likely to be more liquidations.

Aftershocks into 2010

Bain believes the aftershocks of the current recession are likely to be felt well into 2010.

The firm expects bankruptcies of U.S. companies with $100 million or more in assets will approach 100 in 2010. The estimate is based on an analysis of macroeconomic trends including a projected default rate of 7% to 9% of corporate issuers of speculative debt and a $500 billion shift away from consumer spending to consumer savings.

Bain expects 95 to 120 bankruptcies in 2009.

The findings were reported in the Bain CRG Fall 2008 Default Outlook released in early December.

Where trouble lies

All three of the ratings agencies and Bain said the consumer sector is the most exposed.

"We believe that the coming surge in defaults will resemble the early '90s recession and will hit consumer cyclical sectors the hardest," Fitch's Verde said.

That includes gaming, retail, leisure, autos, building and materials and others exposed to consumer spending and housing, she said.

Moody's model indicates the consumer transportation sector will be the most troubled in the United States in 2009 and the durable consumer goods sector will have the highest default rate in Europe.

"There's very little that's been immune so far," Bain's Rovit said.

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