S&P: Junk default outlook improves, but restaurant/retail worsens

By Paul Deckelman

New York, June 22 – The high-yield market appears to be in fairly decent shape, according to some of the measurements that Standard & Poor’s uses to assess market conditions.

Default rates – historically on average a relatively small percentage of the total number of issuers and issues (about 4.5% for United States-based speculative-grade issuers) – spiked upwards in 2016 in response to turmoil in the energy and natural resources sector, S&P managing director Diane Vazza said Thursday.

Vazza told members of CFA New York – the finance industry professional organization formerly known as the New York Society of Security Analysts – at the organization’s 27th annual high-yield bond conference that the U.S. trailing 12-month speculative-grade default rate rose to 5.1% by the end of 2016, with Junkbondland shocked by falling oil and natural gas prices.

After prices started to stabilize around the middle of last year, the 12-month rate began to mostly moderate on a month-by-month basis, coming down to 3.6% at the end of May.

Vazza noted that “importantly, if we took the energy component out of the default rate,” the overall default-rate numbers would be considerably lower – 2.4% this past December and 1.8% in May.

She declared that “we expect default rates to continue to fall,” with the overall U.S. speculative-grade rate, even including oil and gas and the resources sector (metals, mining and steel) slated to come down to 3.3% on an annualized basis by the end of next year’s first quarter.

Vazza termed the European speculative-grade default picture “also fairly benign,” with the corporate default rate expected to fall to 2.1% by the 2018 first quarter’s end. It had risen by 1 percentage point over the past year to 2.4%.

“Unlike the U.S., that had such a concentration of the oil & gas names pushing on the default rate, we didn’t see that in Europe, Vazza said.

Junk returns stay positive

Besides steadily declining default rates, Vazza outlined several other indicators that would seem to indicate a strengthening junk market.

For instance, she noted “for those of you running money” as portfolio managers or other investment professionals that speculative-grade returns have been positive for the past five quarters.

S&P data indicates that the market, on a total-return basis, is up 4% year-to-date, including a gain of 2% for the second quarter through the end of May.

If those returns stay positive when the current second quarter ends next Friday, that will make six straight quarter on the plus side – the first time that will have happened since the first quarter of 2013.

Spreads narrow markedly

Another indicator of credit risk, or the relative lack thereof, is cash spreads over comparable Treasuries, which “have pulled in quite a bit,” driven by a tightening of spreads in the oil and gas sector from their peak levels of about a year and a half ago as energy prices have stabilized. S&P’s composite speculative-grade spreads had tightened to 428 basis points by the end of May – less than half of the 947 bps figure to which spreads had ballooned in February 2016.

“Clearly it was an oil and gas-driven distressed ratio, that has come down as oil and gas has also compressed,” Vazza observed.

That earlier spread figure for the overall high-yield market had come dangerously close to the traditional benchmark definition of distressed debt as having a spread at least 1,000 bps above Treasuries. Vazza noted that in addition to the composite spread figure, S&P’s distressed ratio measuring the percentage of issues on the wrong side of that 1,000 bps demarcation line had also come in drastically, following the same trajectory as spreads themselves – the rating agency’s data indicates that while nearly 35% of all U.S. speculative-grade issues were trading north of 1,000 basis points in February 2016, that figure had shrunk to a little more than 5% by May.

Issuance up to meet due dates

Vazza also looked at new-issuance issuance trends – whether issuance is sufficient to meet the pending “maturity wall” of bonds coming due soon “is always a potential concern when you’re looking at the market and thinking about the market outlook.

But so far, it does not seem to be much of a problem.

She noted that “issuance has been going gangbusters from a slowdown last year,” with companies having “clearly taken advantage of a multi-year window to refinance before hitting a maturity wall.

S&P estimates that some $1.29 trillion in U.S. non-financial corporate speculative-grade debt is scheduled to mature between now and 2021, although the majority of it is not coming due until 2020 or 2021.

Whether the 2021 peak of debt scheduled to come due in the next few years will be a problem “would depend on what your own view is in terms of when the next down-cycle will occur in terms of putting any kind of pressure on refinancing activity,” Vazza said.

But she noted that “every years, we’ve seen the companies able to push out and extend their maturities.”

Refinancing demand “should be manageable.”

Some problem areas

But the situation in the junk market – and in the larger market for speculative-grade debt generally, which also includes leveraged loans as well as junk bonds – is still not without its potential problems.

Vazza noted that even with the oil and gas sector having stabilized from the wholesale bloodletting that was going on early in 2016 as crude prices tumbled badly, dragging energy bonds and loans lower with them, there is “credit risk in oil and gas – there’s still a lot of volatility there.”

When asked during the question-and answer session following her formal presentation what crude oil price might serve as a threshold for pushing up yields in the energy sector, Vazza – noting that she is not an energy analyst – said that many investors were concerned about crude dropping much below $50 per barrel.

And besides energy, another troublesome area has emerged – “retail and restaurants, we see are continuing to have quite a bit of weakness.” She estimated that those companies now make up around 20% of distressed debt, second only to the energy names.

Ticking off a list on sector names which have come under scrutiny, Vazza noted “you have J. Crew has been in the news, Sears, Land’s End, Neiman-Marcus, PF Chang, Charlotte Russe, Guitar Centers – just walk through a mall and you’ll see the list of the bad boys there.”

The problems the retail sector is having could also lead to “contagion” that might spill into related industries and areas, she said.

“Textile and apparel have a lot of weakness. What’s going to be the impact on REITS?” in terms of store closings affecting the profitability of shopping malls. “What’s going to be the impact on CMBS structures?”

She said the problems of the retail sector “bear watching.”

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