High-Yield Storm Warning
S&P analyst warns of wider spreads, defaults amid drop in speculative-grade issuance
By Aleksandrs Rozens October 13, 2008
Last week, Standard & Poor's announced that its composite of speculative grade, or high-yield, debt spreads hit a five-year high.
Late last month, the rating agency also warned that US corporate defaults could rise to more than 23% by 2010--the worst on record since 1981. That means that 353 speculative grade nonfinancial firms could default between 2008 and 2010. As was the case in the 1990-to-1992 period, consumer-sensitive sectors will be among those hardest hit.
So, IDD turned to S&P managing director Diane Vazza to better understand the stress being felt by high-yield debt and how issuance in the high-yield market has dramatically slowed amid the credit crisis.
Diane Vazza
Vazza expects defaults to rise in coming quarters into 2010, but notes that not all defaults lead to bankruptcies. She said the agency expects the economy to bottom in the second quarter of next year, but notes that defaults in the corporate debt world will lag.
Following are excerpts from our recent Q&A:
IDD: High-yield spreads are at 1,055 basis points. What is driving this?
Vazza: What is driving this is the high volatility in the market, lack of transparency in the market, the over-arching recessionary concerns and commensurate pricing [in of] higher default rates.
IDD: What industries are seeing the most widening in spreads of their debt?
Vazza: Financial institutions and banks, clearly. They are really putting pressure on the investment grade [market]. Non-financial companies can still access the market ... at a high rate but less expensively than banks. There is a lot of pressure on banks right now. Banks are not looking to put on any risky assets. We saw over the past couple of quarters, when they responded to the Fed's survey [of loan officers] ... that banks have pulled back.
IDD: When you look at high-yield paper, which are the industries under stress? Auto makers and restaurants--who else?
Vazza: The US automakers. Then you have the auto related [companies], media and entertainment names. Also cyclicals and consumer discretionaries.
IDD: Is any of the widening in yield premiums exacerbated by the drop in bank lending?
Vazza: Absolutely. Investors are saying they want to be compensated for this higher volatility, this increase in risk and the level of uncertainty. Clearly on the investment-grade side it is much more heavily weighted toward fear and a lack of transparency. With speculative grade, we continue to see a pickup in the default rate and we are forecasting a higher default rate in a year. It has been ticking up every month this year. It is still low by historical standards, but the high-yield market is ahead of the widening in terms of the anticipation. The fundamentals, in terms of the credit cycle, are clearly pointing that, with speculative grade the market, [investors] should be pricing in higher risk. We are really on the initial leg of the default cycle at this point.
IDD: What is the all-time wide in your composite of high-yield debt spreads?
Vazza: The most recent wide was in 2002 at 1,100. That was when we were peaking in default rates. Remember that default rates are a lagging indicator. We go through recessionary conditions, then we see a number of companies start to fall even a year later.
IDD: Do you think we'll break through that 1,100?
Vazza: Everyday we are seeing some gapping. You know, I don't know.
IDD: When it comes to defaults, what will be different with defaults around this time? Will they be more severe this time around when you look at the high yield market?
Vazza: Our cumulative worst case [scenario] is a default rate of over 23% by 2010. What that contemplates is that we are going to see defaults pop in the back end of 2009 into 2010.
IDD: Do you also consider the fact that we have second, third and fourth lien debt? A lot of corporations have layered on a lot more debt. Does the second-lien market magnify the losses or speed up the losses?
Vazza: That is factored into our forecasts.
IDD: Within the high-yield basket, is there any industry immune to problems or less likely to see problems with debt? If you look at the drop in consumer spending, there is not a single business that is unaffected.
Vazza: That's right. We have been signaling that for a while. That's reflected in our distressed debt report.
IDD: Is anyone immune to the drop in consumer spending within the basket of high yield issuers?
Vazza: Your consumer discretionary, housing, real estate, automotive, forest products and building materials which are, obviously, related to the housing and real estate market are showing higher risks of being downgraded. On the positive side, there is still some positive momentum on mining, steel, oil and gas and aerospace and defense.
IDD: Who was first to take the hit from the slowdown in housing? Building products and materials, basically anything related to home construction?
Vazza: Yes, but don't forget we've had a lot of negative rating actions already in media and entertainment, restaurant sectors.
IDD: When you look at the issuers of debt running into problems what are some of the common themes? Is it that they cannot refinance readily from one loan to another?
Vazza: They have, effectively, been either shut out due to risk or shut out due to the cost. Yes, the weakest, most credit-frail companies who would need this type of refinancing or cash are effectively being shut out. They don't have the same access. It's expensive. The salad days of the first two quarters of 2007 are over.
IDD: When it comes to defaults, if an issuer defaults, does it automatically result in a bankruptcy?
Vazza: No. For example, we would consider a distressed exchange offer a default if it was coercive and if the amount offered in the exchange was less than par. That could be an example. Or, the default could be cured.
IDD: You said issuance is down sharply. Do you track how many new high yield deals come to market?
Vazza: Yes. Through Sept. 30, there are 101 issues. That is versus 246 last year. That is $37 billion this year versus $107 billion last year. But remember, last year, effectively, was through June 30.
IDD: Because of the credit market lock down last summer?
Vazza: Yes. As of July 1 everything just shuttered last year. When you look at year-to-date comp numbers not a whole lot happened in July, August and September.
IDD: How does this compare with previous declines in issues? This is the lowest in how many years?
Vazza: Today's 101 issues is the lowest [level] since 1991, which had 34 speculative grade issues. The current $37 billion is the lowest since 1996 when it was $35.5 billion. Don't forget that in 1994 you just had $1 billion issued in the whole year.
IDD: Do you expect spreads to keep widening into the fourth quarter because a lot of banks won't take on much risk as the year comes to a close? Could you see us breaking through 1,100 in you composite measure of high yield spreads?
Vazza: Obviously anything is possible. [But] I would rather say it is going to remain highly volatile.
IDD: What is your outlook on issuance this year or next year for high yield?
Vazza: For high yield it is going to remain muted. We continue to see that there is going to be a drought through the end of the year.
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