Distressed Debt Monitor: The U.S. Distress Ratio Falls To 10.8% In March

With positive economic numbers and narrowing spreads, corporate credit conditions in the U.S. slowly continue to improve. The distress ratio decreased to 10.8% as of March 15 from 13.2% as of Feb. 15. The distress ratio continues to fall from its recent high of 19.3% last October, but it is still well above the 5.2% level seen at this time last year. Standard & Poor's distress ratio is the number of distressed securities divided by the total number of speculative-grade-rated issues. Distressed credits are speculative-grade-rated issues that have option-adjusted spreads of more than 1,000 basis points (bps) relative to U.S. Treasuries.

The highlights from this month's distressed credit report are:

• The S&P/LSTA Leveraged Loan Index distress ratio decreased to 5.2% in February from 5.8% in January, while the corporate distress ratio also decreased to 13.2% from 15.3%.
• The default rate, which is a lagging indicator of distress, held steady at 2.4% as of Feb. 29 from the same level at the end of January.
• In March, the number of distressed corporate entities decreased slightly: 126 companies had issues trading with spreads of 1,000 bps and higher as of March 15, down from 150 in February. Also, the number of affected issues decreased to 168 from 203 (for issuer names, see table 3).
• Distressed issues are the weakest of the speculative-grade population. Therefore, their recovery prospects are low. Currently, among the distressed issues with available recovery ratings, about 60.9% have recovery ratings of '5' or '6', indicating only negligible-to-modest recovery in the event of default.
• In addition, 53% of all distressed issues are either unsecured or subordinated notes, and, in the event of default, those noteholders' claims to the related firm's assets are secondary to the more senior debtholders.
• With the decline in the distress ratio, the amount of affected debt also decreased to $69.2 billion as of March 15 from $79 billion as of Feb. 15. Based on debt volume, media and entertainment, high technology, and utilities accounted for 49.4% of the total debt outstanding; media and entertainment alone accounted for about 27.2% of the distressed debt.
• Of the 126 companies on this month's distressed list, 38% had either negative rating outlooks or ratings on CreditWatch with negative implications. The rating outlooks on 53.2% of the companies were stable and 4.8% were positive; 53.2% of the companies were rated 'B-' or lower.

Chart 1

A rising distress ratio reflects an increased need for capital and is typically a precursor to more defaults if accompanied by severe and sustained market disruption. Currently, the variability in the distress ratio, along with various other economic, financial, and credit variables, indicates a mixed outlook for the default rate (see chart 2). Despite the recent positive data on employment and the decline in the unemployment rate to 8.3% in February, the rate remains historically high.

Chart 2

Corporate spreads fluctuated throughout 2011. They increased significantly as a result of the uncertainty in the economy and financial markets and peaked during the first week of October. Spreads have declined somewhat but remain high as uncertainty in the European Economic and Monetary Union (eurozone) persists. On March 15, the speculative-grade spread was at 603 bps, down from 656 bps as of Feb. 15, and the investment-grade spread also decreased to 199 bps from 207 bps. Standard & Poor's distress ratio decreased in March to 10.8% from 13.2% in February.

During the first half of 2011, the U.S. speculative-grade default rate was stable between 2.5% and 3%. It declined to 1.94% at the end of September and then, reversing its trend, rose to 2.06% at the end of October--though remaining considerably lower than the October 2010 rate of 3.4%. The default rate was 1.98% as of year-end 2011, but it rose to 2.4% at the ends of both January and February, reflecting the rising the number of defaults since fourth-quarter 2011.

When the amount of lower-rated issuance (particularly at the 'B-' level and lower) increases as a share of all new speculative-grade issuance for a sustained period of time, it is generally a reliable indicator of imminent defaults. Since early 2003, the share of the lowest-rated credits among all new speculative-grade issues has increased significantly (see chart 3). After plummeting last August, new issuance in the speculative-grade domain has picked up since but has still only averaged 27 issues per month. Thus far in 2012, a total of 123 new speculative-grade issues have come to market in the U.S. through March 21, supported by investor optimism after some strong economic numbers and declining bond spreads. (For more details on new issuance activity, see "Default, Transition, and Recovery: The U.S. Corporate Default Rate Declined Slightly In February To An Estimated 2.33%," published March 2, 2012, on RatingsDirect on the Global Credit Portal.)

Chart 3

Data from the rated universe of issuers indicate that over the long term (1981-2011), an average of 8.6% of all global entities rated 'B-' and 26.8% of all entities rated 'CCC+' and lower transition to default within one year. For higher-rated issuers, the average one-year transitions to default are much lower (for example, 5.5% for 'B' rated entities, 2.5% for 'B+' rated entities, and 1.2% for 'BB-' rated entities).

Movements In Standard & Poor's Distress Ratio

After a positive start to 2011, negative developments in the sovereign debt markets during the second half of the year sparked risk aversion among investors and rising borrowing costs for corporate issuers. Correspondingly, the distress ratio jumped to 19.3% on Oct. 14 from 3.7% on May 15. Since then, relatively calmer economic conditions have helped increase investor confidence, pushing the distress ratio down to 10.8% as of March 15 from 13.2% as of Feb. 15. This is the lowest distress ratio since July 2011, but it is still much higher than the 5.2% level from a year ago (see chart 1). However, despite the decline in the distress ratio from its recent high of 19.3% in October, the 12-month moving average is at its highest point since October 2010.

Despite some positive U.S. economic data, the distress ratio remains high. In February, 168 distressed issues (from 126 issuers) were trading at more than 1,000 bps. The affected debt totaled $69.2 billion, down from $79 billion in December (see chart 4).

Chart 4

Although, in aggregate, the movement of Standard & Poor's distress ratio is roughly parallel to the movement of the speculative-grade default rate (with a lead time of eight to nine months), the distress ratio displays more variation when broken down by industry. The diversified and transportation sectors were the leading sectors of distress as of March 15, with distress ratios of 50% and 25%, respectively (see table 1). However, when combined, these sectors had only nine distressed issues. The media and entertainment sector had the third-highest level, with a distress ratio of 19.5%, and the health care sector followed with a distress ratio of 15.5%.

Table 1

Ten sectors' proportions of total distressed issues increased since February, while nine sectors' decreased. The sector with the largest decline was financial institutions, which fell 2.3% month over month to 3.6%. No other sector saw such a large decline in its proportion of the total from last month. The forest products and building materials sector had the largest increase in its proportion of the total distressed issues for this month relative to February, experiencing a month-over-month increase of 1.4%. In fact, this is the only sector that had an increase in its number of distressed issues in March, while 14 sectors' distressed issue count declined, with an average sector-level decline of 2.57 issues

The homebuilders/real estate sector had no issues trading at 1,000 bps or higher, with no speculative-grade-rated issues, resulting in a distress ratio of zero. This is partially because Standard & Poor's doesn't rate many issuers in the sector.

The media and entertainment sector had the largest proportion of distressed issues by issue count at 27.4% and by distressed amount at 27.2% as of March 15--far more than any other sector. The sector also had one of the highest distress ratios. By proportion of distressed credits, the health care sector is the second largest, with 11.9% of the number of distressed issues. The high technology sector, on the other hand, constituted a more modest 6.5% of the total. However, the high technology sector accounts for a significantly larger proportion of the distressed market by total affected debt than it does by issue count; its average distressed issue size is larger than that of the health care sector. High technology accounted for 11.9% of the total affected debt, compared with 8.4% for health care, implying that this sector's average dollar amount outstanding per distressed issue is higher than the health care sector.

Despite the continued high level of distress in the financial markets, the current negative biases in the largest distressed sectors remain lower than the long-term averages (see table 2). We define negative bias as the proportion of issuers with negative outlooks or ratings on CreditWatch negative. However, these leading distressed sectors have had a large number of low-rated issues in the past three years relative to the distribution of issuer ratings in the U.S. In particular, about 43.5% of the new issues in the health care sector were rated 'B-' or lower during the past three years. By comparison, only 9.6% of the outstanding issuer ratings in the sector are 'B-' or lower.

Table 2

About 58.9% of distressed issues are in the 'CCC'/'C' rating category, with an overall median rating of 'CCC+'. In contrast, 77% of issuers associated with the distressed instruments are rated in the 'B' category, with a median rating for distressed companies (defined as companies that had at least one distressed security) of 'B' as of March 15 (see chart 5). The distress ratio could include nondefaulted instruments of defaulted companies as well as subordinated instruments of higher-rated issuers that might have investment-grade issuer credit ratings. (See table 3 for a full list of all rated U.S.-based companies that have issues trading at distressed levels this month.)

Chart 5

The recovery ratings for the majority of this month's distressed issues predictably fall into the lower ranks, suggesting a higher loss in the event of default. Of the 156 distressed issues with available recovery ratings, 46.2% have the lowest recovery rating of '6', indicating our expectation for negligible (0%-10%) recovery of principal and prepetition interest in the event of default. Despite the initial assumption of very low recovery prospects for issues in this asset class, a few do have recovery ratings of '3' or higher (see chart 6). This month, 28 issues (17.9% of the total) have recovery ratings of '3' or higher, indicating recovery prospects of 50% or greater. (For more details on recovery prospects and ratings, refer to "Piecing Together The Performance Of Defaulted Instruments After The Recent Credit Cycle," published Dec. 1, 2011.)

Chart 6

Although the distressed issues have predominantly weak recovery ratings, a sizable portion is secured instruments with priority claims in the event of default. Of the distressed issues as of March 15, 45.8% are senior secured instruments, compared with 30.4% at the same time in 2011 and only 26.4% in 2010. In fact, this month's proportion of secured issues is an all-time high for our distressed series (see chart 7). However, 53% of the distressed issues are subordinated or unsecured, and these issues generally face lower recovery prospects if the companies default.

Chart 7

Adverse credit conditions increase the burden on companies seeking to refinance their debt as their outstanding bonds reach maturity. The current population of distressed issuers has a total of $41 billion of outstanding bonds reaching maturity between 2013 and 2017 (see chart 8). Of the total, $0.98 billion is due in 2013. Companies facing bond spreads at distressed levels as well as debt issues that will be maturing in the next few years might be unable to borrow or only able to borrow at a high cost, thereby increasing their default vulnerability. The majority (54.5%) of all the debt maturing in this time frame is either subordinated or unsecured, which also potentially reduces recovery prospects.

Chart 8

Table 3