Distressed Debt Monitor: The U.S. Distress Ratio Increased To 16.6% In December--Its Second-Highest Level For The Year

Uncertainty surrounding the European debt crisis continues to depress financial markets around the world. Investors in the region remain risk averse as spreads have widened and the likelihood of a recession in early 2012 has increased. In addition, in the U.S., high unemployment, low consumer confidence, and concerns about the federal budget persist. Amid these conditions, the distress ratio increased to 16.6% on Dec. 9 after declining modestly to 15.7% in November. The distress ratio increased from May through October, reaching its highest point since October 2009 at 19.3% on Oct. 14. 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 Treasuries. Highlights from this month's distressed credit report are:

• The S&P/LSTA Leveraged Loan Index distress ratio bounced back to 6.8% in November from 6.3% in October, while the corporate distress ratio declined to 15.7% from 19.3%.
• The default rate, which is a lagging indicator of distress, rose to 2.06% on Oct. 31 from 1.94% at the end of September.
• In December, the size of the corporate distressed universe reached its second-highest level for 2011 (the highest was in October). A total of 184 companies had issues trading with spreads of 1,000 bps and higher as of Dec. 9, up from 173 in November. Also, the count of affected issues increased to 252 from 238 (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, 60% have recovery ratings of '5' or '6', indicating only negligible to modest recovery in the event of default. In addition, 58% of all distressed issues are either unsecured or subordinated notes, and those noteholders' claims to a firm's assets are secondary to those of more senior debtholders in the event of default.
• With an increase in the distress ratio, the amount of affected debt also rose, to $104 billion as of Dec. 9 from $95 billion on Nov. 15. Based on debt volume, media and entertainment, high technology, and health care accounted for 45.5% of the total debt outstanding. Media and entertainment alone accounted for about 26% of the distressed debt.
• Of the 184 companies on this month's distressed list, 34% had either negative outlooks or ratings on CreditWatch with negative implications. The outlooks on 54% of the companies were stable and 8% were positive, and 44% of 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 a decline to 8.6% in November from 9% the previous month, the unemployment rate remains high. Equity market volatility has declined from its highs of August and September. The ratio of downgrades to total rating actions was 52% in the third quarter, and new issues rated 'B-' and lower as a proportion of total speculative-grade issuance declined slightly in November. However, the results of the latest Federal Reserve survey of lending conditions show that banks are more willing to extend credit to businesses.

Corporate spreads have fluctuated throughout 2011. They increased significantly as a result of the uncertainty in the economy and the financial markets and peaked during the first week of October. Spreads have declined somewhat but remain high as the eurozone uncertainty persists. On Dec. 9, the speculative-grade spread was at 727 bps, up from 717 bps on Oct. 9, while the spread on investment-grade bonds increased to 226 bps from 213 bps. Standard & Poor's distress ratio also increased in December, to 16.6% from 15.7% in November.

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 recent trend, rose to 2.06% at the end of October--though considerably lower than the October 2010 rate of 3.4%. In the U.S., 26 issuers defaulted in the first 10 months of 2011, compared with 47 during the same period in 2010.

Chart 2

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 upcoming default pressure. Since early 2003, the share of the lowest-rated credits among all new speculative-grade issues has increased significantly (see chart 3). After increasing steadily for roughly nine quarters, new issuance in the speculative-grade domain came to a halt in August. Although speculative-grade issuance picked up in November, it's still lower than the average of 47 issues per month during the first seven months of 2011. The number of new speculative-grade issues in the U.S. was four in August, 12 in September, 13 in October, 31 in November, and seven in the first 12 days of December. (For more details on new issuance activity, refer to "Global Weakest Links And Default Rates: The Global Default Rate Increased Slightly In October," published Dec. 2, 2011, on RatingsDirect.)

Data from the rated universe of issuers indicate that over the long term (1981-2010), an average of 9.1% of all global entities rated 'B-' and 27.4% 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 (e.g., 5.9% for 'B' rated entities, 2.6% for 'B+' rated entities, and 1.3% for 'BB-' rated entities).

Chart 3

Movements In Standard & Poor's Distress Ratio

Standard & Poor's distress ratio is the number of high-yield securities trading at spreads greater than 1,000 bps relative to Treasuries, divided by the total number of speculative-grade-rated issues. After a positive start to 2011, developments over the past quarter have sparked an increase in risk aversion among investors and rising borrowing costs for corporate issuers. This was evident in the increase in the distress ratio to 19.3% on Oct. 14 from 3.7% on May 15. The distress ratio declined to 15.7% on Nov. 14 and then rebounded to 16.6% on Dec. 9. The ratio remains above the levels reached in August and September, when the fear of a double-dip recession and the possibility of a European sovereign default spiked (see chart 1). In addition, the distress ratio's 12-month moving average has increased for the past five months after declining steadily for about two years.

Prior to June, activity in the distressed market slowed steadily after a temporary uptick in the spring of 2010 in the wake of Greece's debt troubles and the "flash crash" on May 6, when the Dow dropped nearly 1,000 points in roughly five minutes (it recovered about 600 points by the end of the day). The distress ratio remains high, primarily because of anxiety about a European sovereign default and the effects that could have on the rest of Europe and the banking sector. In December, 252 distressed issues (attributed to 184 issuers) were trading at more than 1,000 bps. This constitutes a distressed universe with affected debt totaling $104 billion, up from $95 billion in November (see chart 4).

Chart 4

Although in the 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 out by industry. The leading sectors of distress as of Dec. 9 were diversified and insurance, which had distress ratios of 100% and 33.3%, respectively (see table 1). However, when combined, these sectors had less than seven distressed issues. Transportation came in third, with a distress ratio of 32.4%, and high technology followed with a distress ratio of 26.8%.

Six sectors have experienced an increase in their proportions of the total distressed universe since November, and 13 sectors have experienced a decrease. The sector with the largest decrease in its proportion of the total was media and entertainment--it fell by 1.4% month over month to 24%. Despite the decline, the sector continues to have the highest proportion of distressed credits. The utility sector also saw a decline in its proportion of total distressed issues, by about 1% from last month. The number of distressed issues in the sector declined to six from eight a month ago.

The health care sector experienced the largest increase in the number of distressed issues. The sector's distress ratio increased sharply in the third quarter after remaining between 1% and 2% during the first half of the year. As of Dec. 9, the distress ratio for the health care sector was 21.6%, the highest for the year and more than double the sector's eight-year (2003-2010) average of 8.4%.

Another sector with a significant month-over-month increase in the proportion of distressed issues was the telecommunications sector. The sector's distress ratio increased from 4.7% on Nov. 14 to 7.8% on Dec. 9, a level not seen since September 2009. However, the sector has only 10 distressed issues--six of which are attributed to only two issuers, Sprint Nextel and Clearwire Communications. Finally, the homebuilders/real estate sector had no issues trading at 1,000 bps or higher, resulting in a distress ratio of zero. This is a result of the sector's small rated universe, with no speculative-grade-rated issues.

Table 1

The media and entertainment sector accounts for 24% of this month's total distressed issue count--far more than any other sector. This sector also accounts for 24% of the affected debt. By number of issues, the high technology and health care sectors account for 8.7% and 10.7%, respectively, of this month's distressed issues. But because 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 accounts for 12.6% of the total affected debt, compared with 8% for health care, implying that this sector's average dollar amount outstanding per distressed issue is higher than the health care sector. Another sector with a high distress ratio is forest products and building materials. As of Dec. 9, this sector's distress ratio was 26.4% based on issue count and 24.4% based on affected debt.

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 with negative implications. 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 30% of the new issues in the high technology sector over the past three years were rated 'B-' or lower. By comparison, only 6% of the outstanding issuer ratings in the sector are 'B-' or lower.

Table 2

About 53% of distressed issues are in the 'CCC'/'C' rating category, with an overall median rating of 'CCC+'. In contrast, 82% 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 Dec. 9 (see chart 5). The distress ratio could include non-defaulted instruments of defaulted companies as well as subordinated instruments of higher-rated issuers that might have investment-grade issuer credit ratings. (For a full list of all rated U.S.-based companies that have issues trading at distressed levels this month, see table 3.)

The recovery ratings for the majority of this month's distressed issues predictably fall into the lower ranks, implying heightened loss in the event of default. Of the 252 distressed issues with available recovery ratings, 44% 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, 38 issues (16% 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 5

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 Dec. 9, 41% are senior secured instruments, compared with 32% at the same time in 2010 and only 20% in 2009. In fact, this month's proportion of secured issues is near an all-time high for our distressed series (see chart 7). However, 59% 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 $67 billion of outstanding bonds reaching maturity between 2013 and 2017 (see chart 8). Of the total, $3.1 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 find themselves unable to borrow or only able to borrow at a high cost, thereby increasing their default vulnerability. The majority (63%) of all the debt maturing in this time frame is either subordinated or unsecured, which also potentially reduces recovery prospects.

Chart 8

Table 3