Most Corporate Bonds Are Now Junk
09/11/2007 12:00 am EST
Diane Vazza, managing director of S&P Ratings Services, says that as the majority of debt rated by her firm drops below investment grade, the risk of default is rising.
Nearly 51% of debt rated by Standard & Poor's Ratings Services (which operates independently of S&P Equity Research) is now considered speculative grade.
A decade-long shift towards more aggressive corporate financial strategies and continued evolution of the leveraged finance market combined to shift our median rating for nonfinancial issuers to BB- in 2007 from BBB- in 1997.
The ratings mix continues to deteriorate, as firms borrow to buy back shares and make acquisitions. The number of AAA-rated issuers has declined from its peak in 1998. Only six nonfinancial companies now carry S&P's highest rating.
An AAA rating requires firms to fit a conservative and risk-averse profile, which places constraints on organizations in a competitive environment. Also, maintaining AAA status does not yield the payoff it once did. The spread difference between a ten-year, AAA-rated industrial, for example, and an AA-rated firm is very narrow.
However, the key force in the downward shift in the ratings distribution has been new entries into the bond market. Through the first two quarters of 2007, 70% of the 158 new entrants were rated B. While investors have lost some of their risk appetite, they still afford speculative-grade issuers relatively low financing terms (with yields around 9%).
Mergers and acquisitions (M&A) have contributed to the deterioration in credit quality. Recent leveraged buyouts have caused firms to slip multiple notches on the ratings scale. Through July, there had been 30 M&A-related downgrades of parent-level firms in the United States, outpacing 20 during the same period in 2006.
We believe the current ratings profile has heightened the risk in the US corporate bond market. With 27% of CCC-and-below rated firms and 11% of B-firms transitioning to default within a year (based on the historical experience between 1981 and 2006), the glut of firms at the B-rating level poses significant default risk.
However, in the near term, we forecast only a modest rise in the default rate to 1.4% by year-end from 1.2% at the end of June 2007. Only the financial (86%), utility (80%) and real estate (71%) sectors remain predominantly investment grade. The media and leisure sector has the highest percentage of firms in speculative-grade territory (85%), followed by the telecommunications (77%) and health care (75%) sectors.
Over the past few years, firms have become more willing to use leverage to meet shareholders' expectations, while investors have increased their risk appetite in search of yield. This has combined to transform the speculative-grade ranks to 60% in the B rating category from BB-dominated as recently as 1996.
The continued downward movement of speculative-grade issuers has increased future default risk, by our analysis. The inflow of new issuers in the B category poses a significant risk, as 55% of all defaulters from 1980 to the first quarter of 2007 were in the B rating category at origination.