Outlook 2012: Default rate expected to see increase in year ahead

By Aleesia Forni

Columbus, Ohio, Dec. 30 - The speculative-grade default rate is expected to increase in the upcoming months, according to recent projections made by three major rating agencies.

Fitch Ratings believes additional stress at the CCC borrowers level will push the U.S. high-yield default rate to a range of 2.5% to 3.0% in 2012. This is below its long-term average annual default rate of 5.1%.

Fitch's year-to-date default rate hit 1.4%, compared to 0.8% in October.

Moody' Investors Service expects the global speculative-grade default rate to fall to 1.7% by the end of the year but reach 2.4% by November 2012.

Moody's trailing 12-month global speculative-grade default rate fell to 1.8% in November from 1.9% in October, according to its monthly default report.

Standard & Poor's expects the U.S. corporate trailing 12-month speculative-grade default rate to rise to 3.1% by September 2012 from 1.94% at the end of September 2011.

"The pathway for default has been lower every month, and this is the first sign of a turnaround where we're starting to see a pickup," Diane Vazza, managing director and head of global fixed income research at S&P, told Prospect News.

Sectors that are experiencing secular changes will continue to face difficulties as all three agencies believe industries exposed to discretionary consumer spending will see challenges.

"Here, it's all a question of sustainable leverage in a low growth and likely volatile economic climate," Mariarosa Verde, managing director of Fitch Credit Market Research, said.

Media sector to see stress

Both S&P and Moody's expect the highest default rates to be in the media and entertainment industries.

Banks, consumer products, advertising and publishing sectors are expected to be hit hard, as well.

Another factor affecting the default rate is Europe's economic climate, which could "very easily infect the U.S.," according to Vazza.

"If another macro shock emerges that disrupts business and consumer confidence, such as a further deterioration in the European debt crisis, it could certainly push the default rate higher," Verde said.

"Fortunately, outside of the very bottom of the rating scale, we see good fundamentals for high-yield issuers, and this should provide some cushion."

While the year-to-date default rate remained a "modest" 1.4%, Fitch reported November's $6.4 billion in defaults equates to an annualized default rate of 7%, both on a par basis and also an issuer basis.

Defaults from January to June totaled $2.1 billion, while defaults from July to November totaled $12.8 billion, according to Fitch.

Fitch notes refinancing surge

Fitch reported that the year-to-date default rate rose to 1.4% from 0.8% in October due in part to the bankruptcy filings of American Airlines and power generator Dynergy Inc.

The seasoning of transactions brought to market from 2009 to 2011 will also contribute to defaults beginning in 2012 and continue into 2013 through 2015, according to its 2012 outlook report, published in late December.

"In fact, we had a huge surge in refinancing in 2010 and 2011, and this contributed to the very low default rates recorded over the two years," Verde said.

Default rates on issuance pools have been quite low at 0.3% for 2010 and 0.5% for 2011, and Fitch believes "this is not sustainable."

"As we look ahead to 2012, refinancing as a short-term fix will take a back seat to cash flow growth and operating success," Verde added.

The operating success of these companies will be tested in the future, especially with the anticipated below-trend economy.

"Many of the companies that refinanced over this period will enter the second to third year after issuance, and that is when we start to see more defaults," Verde said.

Fitch believes struggling companies will have a tougher time refinancing in this current environment than in 2010 or early 2011.

"The reason for this is that growth expectations have been cut," Verde said. "There is more risk aversion than earlier this year and more skepticism surrounding the viability of companies under stress."

Still, apart from the 'CCC' space, high-yield fundamentals remain "quite good," supporting Fitch's prediction of another below-average default year in 2012.

According to financial data Fitch has compiled, there is a renewed focus on business investment.

However, the extent to which the European debt crisis disrupts this activity remains to be seen.

"November's pop shows that default conditions in recent months have shifted away from the ultra-benign environment seen earlier in 2011," the report said.

This is due to the weak growth during the first half of the year, combined with the effect of the European debt crisis.

Fitch believes this elevated level of default activity will continue into 2012.

"The bulk of defaults will continue to come from the very bottom of the rating scale where weak and inconsistent economic activity, industry-specific challenges, and greater risk aversion in the funding markets will necessitate additional debt restructurings," the report said.

S&P: Default indicators mixed

S&P's baseline projection for 2012 is lower than its long-term average of 4.59%.

To reach this projection, a total of 48 issuers would need to default between October 2011 and September 2012, according to the agency's latest default report.

The agency added that 28 speculative-grade issuers defaulted from October 2010 to September 2011 by comparison.

Certain indicators of default have shown "marked improvements" in the recent past, while others remain unfavorable.

"The economy continues to recover at half speed, and contagion from Europe's sovereign debt crisis remains a risk," the report said.

"As a result, investor confidence is waning."

The distress ratio, which S&P defines as the proportion of speculative-grade bonds with option-adjusted spreads above 1,000 bps, increased to 19.3% as of Oct. 15, up from 14.9% in September, 5.9% in June and 5.2% in March.

S&P believes there are many companies that are vulnerable to default in the long term, which is in line with the increase in its default rate thinking.

"We've had a weak economy all year, and this is a continued fallout of a weak economy," Vazza said.

"Our thinking going forward is we've really had mixed metrics in terms of the economic data coming out, so we continue to see weakness in 2012."

S&P believes maturities will be manageable for the remainder of 2011 and into 2012, thought it sees weakness heading into 2013 and 2014.

While unemployment, the distress ratio and volatility spurred by the global economy have risen, the results of the Fed's Loan Officer Survey show that banks are more willing to lend to corporations.

With fewer downgrades in recent quarters, credit quality has strengthened, which should help companies mitigate the effects of "lackluster" economic growth and uncertainty in the financial markets.

Globally, the U.S. had the highest number of issuers rated B- and lower with either negative outlooks or ratings on CreditWatch with negative implications.

November tops for defaults

Moody's said November's rate exactly matched its forecast from one year ago.

The speculative-grade default rate held steady at 2.0% in November in the United States, marking the third month at this level.

The default rate in Europe fell to 2.5% in November from 2.6% in October, according to the report.

However, Moody's said this decline is the result of more issuers in the denominator for November's rate, not the result of fewer defaults.

"We recorded more defaults in November than in any other month in 2011," Moody's Albert Metz said in the report.

"However, on a year-over-year basis, the corporate default rate is closely tracking our baseline forecasts."

In November, there were 10 defaults of Moody's-rated corporate debt issuers, including eight in the United States and two in Europe.

This brought the year-to-date total to 31.

Moody's global speculative-grade bond default rate remained unchanged by dollar volume at 1.6% from October to November.

The ratings agency's U.S. dollar-weighted speculative-grade bond default rate edged higher to 1.2% in November from 1.1% in October. The rate came in at 3.3% in November in Europe, down from October's revised 3.5% rate.

No Moody's-rated loans defaulted in November in the leveraged loan market.

The trailing 12-month U.S. leveraged loan default rate ended November at 0.8%, down from 1.2% in October.

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