Default rate hits 25-year low – what could be more reassuring than that? Incongruous as it seems in this febrile environment, the trailing 12-month global default rate for corporate speculative-grade bonds declined in November to just 0.74 per cent, according to Standard & Poor’s.
Trailing default data may not look alarming, but more and more warning lights are blinking red. In the same month that default rates continued falling, the number of US corporate issuers being downgraded by Moody’s relative to those being upgraded leapt. At almost 4.5 times, that is more than double the rate for October and the highest since December 2002, according to CreditSights. Monthly data are volatile but the 12-month moving average has been increasing steadily since June. The number of debt issues falling into the distressed category – those trading at a spread to US Treasuries of more than 10 percentage points – has also risen. At 159 issues, the number in Merrill Lynch’s Distressed index is up more than seven-fold since January.
It is possible that rating agencies, stung by growing criticism, are taking a more aggressive approach to ratings. High-yield bulls also point to the fact that for some time many have been calling, incorrectly, for a turn in the cycle. Junk bonds are yielding about 550 basis points more than 10-year Treasuries right now. When risk premiums get this high, it can sometimes pay to target lower-rated issues. According to data from Leverage World, single-B rated paper outperformed double-B rated bonds in the aftermath of the 1998 crisis.
But we are a long way from 1998. Far from calming financial markets with a swift rescue plan, the Federal Reserve is still struggling to persuade banks to lend to one another on reasonable terms. For years, the “originate-repackage-distribute” model of structured finance has helped keep default rates low – by permitting extensive refinancing – even as credit quality has crumbled. With that support seemingly closed off, the turn in default rates looks set for 2008.