2011 Annual Global Corporate Default Study And Rating Transitions

Despite fewer financial and economic headlines than in the past four years, 2011 was still a year of unprecedented events in global credit markets, marked by sovereign downgrades, most notably the U.S. In 2011, 53 global corporate issuers defaulted, down from 81 defaults in 2010 and the record high of 265 in 2009 (see table 1). One of the 53 defaulters began the year rated investment grade (MF Global Holdings Ltd.). The debt amount affected by these defaults fell to $84.2 billion, from $95.7 billion in 2010.

Overall credit stability deteriorated slightly in 2011 (see table 6). Both upgrades and downgrades increased relative to 2010, as did the proportion of withdrawn ratings. In addition, the average number of notches recorded among downgrades fell in 2011 to 1.4 versus 1.52 the previous year (see chart 13).

All but one of the defaulted companies in 2011 that began the year with active ratings (44) came from the speculative-grade universe (see table 1). Of the remaining nine, Standard & Poor's Ratings Services assigned ratings on five companies during 2011, and four began the year with withdrawn ratings. Also, of the 53 total defaulters, 47 were initially rated speculative grade, with the majority (39) from the 'B' and 'CCC'/'C' rating categories.

At the end of December 2011, the speculative-grade default rates fell to 1.98% in the U.S., 0.59% in the emerging markets, and 5.98% in an assorted grouping of other developed markets (including Australia, Canada, Japan, and New Zealand). In Europe, however, the default rate rose slightly at year-end 2011, to 1.6% (see table 7). When including all rated entities, the global default rate declined to 0.75% in 2011 from 1.15% a year earlier.

This study includes industrials, utilities, financial institutions (which includes banks, brokerages, asset managers, and other financial entities), and insurance companies around the world with long-term local-currency ratings. All default rates reported are calculated on an issuer-weighted basis. For a detailed explanation of the data sources and methodology used in the study, please refer to Appendix I.

Although the incidence of default fell for the second year in a row following the height of the credit crisis in 2009, the one-year Gini ratio--a key measure of the relative ability of ratings to differentiate risk--declined slightly, to 88.7% in 2011 from 90.1% in 2010. One of the main contributors to the recent decline was the default of MF Global Holdings Ltd., which began the year rated 'BBB-'. Despite the drop in the Gini ratio, it's still at its sixth-highest level in the 31-year history of the database (see chart 30) and is higher than the one-year average of 84.2% (see table 2). (For details on the Gini methodology, refer to Appendix III.) Further testifying to the relative decline in default activity in 2011, transportation was the only sector that recorded an annual default rate in excess of its long-term weighted average (see chart 2). The default rates in this study that we refer to as weighted averages use the number of issuers at the beginning of each year as the basis for each year's weight. When broken out by rating, every rating category had an annual default rate in 2011 that was below its long-term average (see table 9).

Table 1

Chart 1

Chart 2

The Gini ratios are a measure of the rank-ordering power of ratings over a given time horizon--i.e., one through seven years (see chart 3). It shows the ratio of actual rank-ordering performance to theoretically perfect rank ordering.

Chart 3

All of Standard & Poor's default studies have found a clear correlation between ratings and defaults: The higher the rating, the lower the observed frequency of default, and vice versa. Over each time span, lower ratings correspond to higher default rates (see chart 4 and chart 25). We found that the same is true when we broke out the data by rating (see tables 24 and 26), as well as by region (see table 25). As the Gini ratios show, the ability of corporate ratings to serve as an effective measure of relative risk remains intact, particularly in low-default years. Many default studies, including this one, also look at transition rates, which gauge the degree to which ratings change--either up or down--over a particular time. Transition studies have repeatedly confirmed that higher ratings tend to be more stable and that speculative-grade ratings generally experience more volatility. However, with the downgrade of the U.S. (AA+/Negative/A-1+) and other sovereigns in 2011, many corporations--particularly in the financial sector--with ratings tied to the countries they operate in experienced subsequent downgrades. This decreased the relative stability of rating categories with smaller sample sizes, such as 'AAA'.

Table 2

Chart 4

With the exception of MF Global, all of the defaulters in 2011 began the year rated in the lowest rating categories--particularly 'B' and 'CCC'/'C' (see table 3). One-year default rates are now close to levels not seen since prior to the financial crisis that began in late 2007, while all rating categories finished 2011 with one-year default rates well below their long-term weighted averages (see table 4). This was especially the case among the lowest-rated companies. Once again, the default rate in the 'AAA' rating category was zero, demonstrating that the default record for corporate ratings in this category remained unblemished and consistent with historical trends.

Table 3

Table 4

2011 Summary

Below are some key takeaways from the 2011 defaulters:

• After hitting an all-time high of 265 defaults in 2009, the count of defaulting companies fell off considerably in 2011, to 53. This includes publicly and confidentially rated entities as well as entities that were not rated at the time of default (see chart 5).
• By count, the U.S. and associated tax havens (Bermuda and the Cayman Islands) accounted for the majority of defaults, with 39, while the other developed nations had seven, and Europe accounted for only four. Within the emerging markets, Israel, the United Arab Emirates, and the Russian Federation recorded one default each.
• Although distressed exchanges have remained popular over the last few years, missed principal or interest payments were responsible for the largest proportion of defaults in 2011, at 43% of the total. Distressed exchanges accounted for 23% of all defaults.
• As of Dec. 31, 2011, 12-month-trailing speculative-grade default rates had fallen considerably from a year earlier. The global speculative-grade default rate was 1.71% at the end of 2011, with breakouts of 1.98% in the U.S., 1.59% in Europe, and 0.58% in the emerging markets (see table 7). If we include all rated corporate entities, the default rates were 0.75% globally, 1.04% in the U.S., 0.34% in Europe, and 0.33% in the emerging markets.
• Of the 44 defaulters that were rated at the beginning of the year, 43 were speculative grade ('BB+' or lower). Of the remainder, nine were not rated at the beginning of the year, and one began the year rated investment grade.
• Of the entities that defaulted last year (and that had ratings as of Jan. 1, 2011), 77.3% were rated 'B-' or lower at the start of the year.
• Global corporate bond issuance declined in 2011, with 8,377 new issues coming to market during the year, down from 8,549 in 2010. Both the speculative-grade and investment-grade segments saw decreases, with high yield falling to 639, and investment grade dropping to 2,971. Some of the falloff in new issuance stemmed from the increase in unrated new issuance in 2011. At the issuer level, Standard & Poor's assigned first ratings on 712 entities in 2011, the third-highest annual total, though still down from 742 in 2010. We note that we consider companies that reemerge from default--including distressed exchanges--as new entities for the purposes of this study.
• After the downgrade of the U.S. in August, corporate bond spreads immediately widened and remained elevated for the remainder of the year. Speculative-grade corporate bond spreads finished 2011 at 723 basis points (bps), compared with 538 bps at the start of the year. Investment-grade spreads ended 2011 at 224 bps, compared with 177 bps on Jan. 1.
• Alongside corporate bond spreads, CDS spreads also were higher at the end of the year after tumultuous events with sovereigns. The Markit Partners five-year North American High-Yield composite index rose to 6.8 on Dec. 30 from 4.2 at the beginning of the year, and it reached a high of 8.8 on Oct. 3. The European and Emerging Markets' series also showed similar increases.
• The outstanding debt volume affected by defaults also fell in 2011, to $84.3 billion, after posting an all-time high of $627 billion in 2009 (see chart 6).
• Texas Competitive Electric Holdings Co. LLC was the single largest defaulter in 2011 based on debt volume. The company accounted for $32.46 billion in debt, which is nearly 40% of the total amount affected by defaults in 2011 (see table 5). Texas Competitive Electric completed a distressed exchange on April 20. The exchange was an "amend and extend," in which the company received lender consent to extend the maturities on a portion of its senior secured credit facilities to 2016-2017 from 2013-2014.
• The number of 'AAA' rated entities dropped significantly in 2011, as several 'AAA' rated financial institutions and insurance companies with ratings implicitly tied to that on the U.S. government were downgraded shortly after the Aug. 5 downgrade of U.S. debt. This leaves only four 'AAA' rated companies in the U.S.--all from nonfinancial sectors. They are Automatic Data Processing Inc., Johnson & Johnson, Microsoft Corp., and ExxonMobil Corp.
• Of the global total, five confidentially rated issuers defaulted.
• A total of six defaulters were initially rated 'BBB-' or higher, whereas 39 companies (74% of all defaults in 2011) were initially rated 'B+' or lower.
• Of the defaulted entities that Standard & Poor's initially rated investment grade, the average time to default--the time between first rating and date of default--was 17.4 years, with an associated standard deviation of 9.76 years.
• In contrast, the average time to default among entities initially rated 'BB+' or lower was 4.16 years, with an associated standard deviation of 3.45 years.
• For all of the issuers that defaulted in 2011, the average time to default from first rating was 5.66 years, and the median was 4.83 years.
• The issuer with the longest time to default in 2011 was U.S.-based AMR Corp., which took 30.9 years to default from its initial rating of 'BBB-'.
• At the opposite end of the spectrum, the issuer with the shortest time to default--0.04 years--was U.S.-based transportation company Trailer Bridge Inc. The company failed to make principal and interest payments on its senior secured debt only 15 days after the rating on the company was raised to 'CC' after a prior selective default.
• As was the case in 2010, the consumer/service sector recorded the highest number of defaults worldwide relative to other sectors (11). All of the default activity in this sector occurred in the U.S.

Annual Global Trends

After a record number of corporate defaults in 2009, the count fell in 2011 for the second straight year (see chart 5), as did the amount of affected debt (see chart 6). As it has in the past, the U.S. accounted for the majority of both default counts and affected debt in 2011. This is mostly attributable to the larger rated population in the U.S. The largest defaulter by debt amount outstanding was Texas Competitive Electric Holdings Co. LLC., which extended the maturities on a portion of its senior secured credit facilities in April, thus constituting a distressed exchange. This, combined with its other outstanding issues, raised the issuer's total affected debt to $32.5 billion. Although sizable, this is a more modest amount compared with the largest defaulters of the previous three years (see table 5).

Default activity may have subsided in 2011, but rating actions (both upgrades and downgrades) and withdrawals were more frequent (see table 6). As they did in 2010, upgrades outnumbered downgrades in 2011, but by a smaller margin, pushing the downgrade-to-upgrade ratio to near parity at 0.96. The percentage of withdrawn ratings also increased in 2011. As a result of the rise in rating actions and withdrawals, the percentage of unchanged ratings fell below the series long-term average of 70.9%.

Table 5

Chart 5

Chart 6

Table 6

Although the percentage of global corporate issuers that experienced ratings changes may have increased in 2011, the upgrades and downgrades were mild in magnitude. Only two entities experienced downgrades of seven notches or more in 2011. This is roughly in line with the three in 2010 and is the lowest level since 2006, when the total was also two (see chart 7). The issuers that experienced significant downgrades in 2011 were MF Global and New Zealand-based Western Pacific Insurance Ltd., both of which were downgraded to 'D'.

Chart 7

The overall issuer-weighted default rate--including both investment-grade and speculative-grade entities-was 0.75% in 2011, the lowest since 2007. By region, the corresponding rates were 1.04% in the U.S., 0.34% in Europe, and 0.33% in the emerging markets.

Despite titanic developments in U.S. and European credit markets, default activity was muted in many regions in 2011. On a trailing-12-month basis, the global speculative-grade default rate fell to 1.7% in 2011 from 2.8% at the end of 2010 and is now solidly below its long-term average of 4.3%. In the U.S. region, the speculative-grade default rate was 1.98% at the end of 2011, down from 3.3% in 2010 and well below the 4.4% long-term average. Within Europe, the speculative-grade default rate rose to 1.6% from 1% in 2010 but remains below the region's 3.2% long-term average. In the emerging markets, the speculative-grade default rate finished 2011 just below 0.6%, its lowest level since 2007 (see table 7 and chart 21). Among all major regions, the only to still experience a relatively higher speculative-grade default rate for 2011 was the other developed region.

Table 7

Data on defaulted corporate issuers globally indicate that defaults among speculative-grade entities tend to be clustered in the third year after the initial rating, particularly in the 'B' rating category (see chart 8). For example, among defaulters that were rated 'B' at origination, the default rate climbs to a high of 19.1% in the first three years and then decelerates thereafter. Defaulted issuers initially rated 'BB' show a similar pattern but peak a little later--in the fourth year. Conversely, defaulters initially rated 'CCC' show the reverse, with the highest default rate observed in the first year, which is not surprising given the low rating.

Chart 8

In 2011, 47 (or 89%) of the 53 defaulted entities were originally rated speculative grade ('BB+' or lower), which is slightly higher than the long-term average of 85.9%. This is typical in years with lower default rates. The rating path observed for defaulters in the trailing 12 quarters is broadly representative of the long-term ratings trend, which shows that both the average rating and median rating on all defaulting entities were in the speculative-grade category in the five years preceding default (see chart 9).

Financial institutions and insurance companies are particularly sensitive to sudden declines in investor confidence, which can result in a relatively fast descent into default (see chart 10). This was especially evident during the recent financial crisis, as many highly rated banks defaulted within a short amount of time from their initial downgrades during this period. Conversely, nonfinancial defaulters travel a much slower, smoother, and shorter path to default (see chart 11).

Chart 9

Chart 10

Chart 11

Some issuers default when they are no longer rated (NR) by Standard & Poor's. We make our best effort to capture such defaults in the database, and we include them in the annual default rate calculations if an entity was rated as of Jan. 1 in the year of default. If, however, Standard & Poor's withdrew the rating prior to Jan. 1 of the year of default, we did not include the issuer in the default rate calculation in that year. Of the 53 defaulted companies in 2011, 9.4% were not rated just prior to default, which is roughly half the long-term average of 18.7% (see chart 12A). Furthermore, although 'NR' defaulters are not always captured in the default rate calculation for the year of default, we do capture such defaults in the longer-term cumulative default rate statistics, tagged back to the year in which they were last rated. Charts 12A and 12B also present another example testifying to the broadly positive performance of corporate ratings and the credit environment as a whole. All of the defaulters in 2011 that had active ratings immediately prior to default were rated in the lowest rating categories. In particular, 83% were rated 'CCC+' or lower prior to default, much higher than the 62.4% long-term average.

Chart 12A

Chart 12B

Table 8 provides a list of all the nonconfidentially rated defaults recorded in 2011. For details on the 2011 defaulters, see "2011 Default Synopses."

Table 8

As demonstrated earlier, large notch movements diminished in number in 2011. This also applies to the average notch movement relative to prior years. In terms of both upgrades and downgrades, 2011 saw the most muted levels of both average upgrades and downgrades in absolute terms (see chart 13). At the end of 2011, the average notch upgrade was 1.16, and the average notch downgrade was 1.4. These deviations from the long-term averages are the largest for both series since before the turn of the century.

Chart 13

Table 9

2011 Timeline: Sovereigns Take Center Stage

After 2010 finished in generally positive terms for financial markets, 2011 got off to an uneventful, if not positive start. However that ultimately changed, as events in sovereign debt markets had effects that spilled over to corporate borrowers. In North America, the unprecedented downgrade of the U.S. in early August rocked equity markets, albeit relatively briefly, while the impact on corporate debt markets was more prolonged. In Europe, a series of sovereign downgrades and the seemingly perpetual prospect of a default by Greece contributed to a lethargic recovery globally. As the year progressed, volatility permeated equity markets, while corporations' borrowing costs rose, as did the cost of insuring that debt in the event of a default. Default activity remained muted throughout most of the year, though it picked up in the fourth quarter, which pointed to more investor uncertainty and caution heading into the new year.

After gaining roughly 11% in 2010, the Dow Jones Industrial Average (DJIA) started the year at 11,578, still pushing forward in its long recovery from a low of 6,547 on March 9, 2009. Equity market volatility, as measured by the Chicago Board Options Exchange Market Volatility Index (VIX), was also relatively benign at the start of the year, at 17.6 on Jan. 3. In a potential sign of market demand to come, social network giant Facebook raised $500 million in a private offering spearheaded by Goldman Sachs on Jan. 4, valuing the company at $50 billion. From there, it didn't take long for dramatic headlines to hit. After weeks of civilian protests and clashes with authorities, in mid-January Tunisian President Zine el-Ablidine Ben Ali was overthrown, with the remaining politicians setting up a caretaker government in place until new elections are held. This was the beginning of a series of protests and civil wars across the Arab world that resulted in the departure of several existing governments in the region.

Later in the month, protests broke out in Egypt, the Arab world's most populous country, which resulted in President Hosni Mubarak stepping down from office on Feb. 11. Meanwhile, on the economic and financial fronts, official numbers came in during February to confirm that China had overtaken Japan in 2010 to become the world's second-largest economy. Given China's sustained remarkable growth rates, in April the International Monetary Fund (IMF) estimated that it would overtake the U.S. as the world's largest economy (based on comparative purchasing power) by 2016--the first time the IMF has put a time frame on the event.

Toward the end of February, antigovernment protests turned into outright rebellion in Libya, resulting in a brief civil war. Many of the country's ports came under attack and ultimately closed, cutting off Libyan oil exports. In early March, President Obama called for long-time Libyan leader Moammar Gadhafi to give up power. As these events unfolded, markets reacted, pushing the VIX up above 20 for the first time in the year.

Meanwhile, New Zealand experienced a 6.3 magnitude earthquake in Christchurch, the country's second-largest city. Only a week or so later, a 9.0 magnitude earthquake and subsequent tsunami hit Japan. The devastation from the tsunami caused significant damage to the country's nuclear reactors and disrupted regional and global supply chains for an extended period. Japan's Nikkei dropped more than 6% on its first day of trading after the disaster, and the DJIA followed suit. Shortly after, the VIX, U.S. corporate bond spreads, and credit default swap (CDS) rates all spiked briefly.

On April 7, Portugal announced it would ask the EU for a financial bailout. This came a week after the country's second downgrade since the beginning of 2011, bringing the country to within one notch of a speculative-grade rating. Only a few weeks later, on the other side of the Atlantic, President Obama called for a plan to reduce the U.S. deficit by $4 trillion in the next 12 years through a combination of increasing revenue and reductions in spending. Not convinced a compromise would be reached, Standard & Poor's revised its outlook on the U.S. to negative on April 18. On April 23, antigovernment protests spread to Syria, where the clashes between civilians and security forces were more intense than in other countries, with the exception of Egypt. The political upheaval across the Arab world sparked multiple downgrades throughout the year. Standard & Poor's downgraded Bahrain, Tunisia, and Jordan twice each, and it lowered its ratings on Egypt three times, to 'B+' from 'BBB-' at the beginning of the year.

On May 9, Standard & Poor's downgraded Greece for the second time in 2011, citing an increased likelihood of a rescheduling of the country's commercial debt, which would constitute a selective default. Throughout the first half of 2011, corporate borrowing costs remained near record lows, opening the door to additional funding. Corporate lending conditions were so attractive that on May 17, Google went to market with its first debt issue. The total was $3 billion. Standard & Poor's first assigned a rating on Google on July 15, 2010. Meanwhile, reminders of the extent of the recent financial crisis appeared. In positive news, on May 25, the U.S. Treasury and American International Group (AIG) sold $8.7 billion worth of shares in a stock offering. It produced a small profit for taxpayers nearly two and a half years after the government provided AIG with a massive bailout. Despite this bit of positive news in the aftermath of the crisis, housing information released on June 1 indicated that home prices within the U.S. had retreated to levels not seen since 2002.

The third quarter of 2011 began with increased stress on sovereigns. On July 6, Moody's downgraded Portugal to speculative grade (Standard & Poor's later downgraded Portugal two notches, to 'BB', on Jan. 13, 2012). A week later, Moody's also downgraded Ireland to speculative-grade status, and on July 27, Standard & Poor's lowered its rating on Greece for the last time in 2011--to 'CC'--in anticipation of its eventual selective default.

In mid-July, amid the possibility that the U.S. Congress would not raise the debt limit in time, the ratings agencies warned of a possible downgrade of the U.S. government. The political bickering carried on for the rest of the month, until eventually the debt ceiling was raised on Aug. 1. Although this was passed before the official deadline, Standard & Poor's lowered its debt rating on the U.S. on Aug. 5. This wasn't a surprise, but it was still an unprecedented move. The downgrade had enormous repercussions for 'AAA' rated entities in the U.S.--more than 82% of them were subsequently downgraded to 'AA+'. Borrowing costs for U.S.- based corporations also increased, and not just at the highest rating levels. The speculative-grade corporate bond spread widened by more than 46 basis points (bps) by the close of the next business day, and it continued to rise before reaching a high of 830 bps on Oct. 4. CDS markets also responded to the news, with the Markit North American High-Yield series expanding by more than 1% by the end of the next business day as well. This series spiked to nearly 9% by October from a low for the year of 3.8% in early February. Perhaps contrary to expectations, the yield on the U.S. Treasury's 10-year note dropped below 2% by the end of September as investors search for a safe-haven investment intensified.

Despite the market volatility, defaults within the corporate sector remained muted. In September, only two companies defaulted globally. The impact on consumers, however, was becoming more severe. On Sept. 14, statistics released showed that the median family income in the U.S. dropped to 1996 levels, well before the recent financial crisis began. In an effort to boost the economy yet again, the Federal Reserve implemented another round of open market transactions similar to QE1 and QE2, this time referred to as "Operation Twist," in which the Fed purchased $2.65 trillion of long-term Treasuries by selling an equivalent amount of shorter-term government debt with the aim of lowering long-term rates for the real economy. Internationally, Standard & Poor's downgraded Italy by one notch to 'A' on Sept. 19 amid more concerns over Europe. Standard & Poor's also lowered its ratings on Belarus and Ukraine during the month, but both were already solidly in speculative-grade territory.

In yet another sign of continued uneasiness regarding Europe, Standard & Poor's downgraded Spain on Oct. 13 owing to uncertainty in its financial system as well as its debt load and persistently high unemployment levels. This came just days after other ratings agencies downgraded both Spain and Italy. At this time, both the high-yield corporate spread in the U.S. and the Markit North American High–Yield CDS series hit their highs for 2011--suggesting that market disruptions in one region spread to others in the developed world.

Corporate defaults increased in October, to eight globally, up from two in September and four in August. Among these was the only investment-grade defaulter of 2011--MF Global, which filed for Chapter 11 bankruptcy protection on Oct. 31. Shortly after filing for bankruptcy, the firm came under increased scrutiny for approximately $1.2 billion worth of customer funds that it could not account for. The U.S. municipal debt market also took a hit in October with the bankruptcy filing of Harrisburg, Pennsylvania, the state's capital.

November was no less calm for global financial markets. Early in the month, European leaders called for Greece to formally declare its intention to remain a member of the eurozone after the Greek prime minister called for a referendum on the bailout plan. In terms of rating actions, Standard & Poor's downgraded eight sovereigns in November, and eight corporate entities defaulted in the month.

In the final month of 2011, the Fed and other central banks made coordinated efforts to make borrowing and lending easier for European banks. Much of this would involve dollar loans to foreign banks at favorable rates with the intention of providing more liquidity and time to the European region in the hopes that leaders there could work out a solution in the meantime. Nonetheless, markets remained skeptical about policymakers' ability to contain the turmoil in Europe, as reflected in the declining value of the euro. Many central banks within Europe even began planning for the possibility of countries leaving the eurozone or even of the currency zone falling apart. The European Central Bank also extended nearly $650 billion in low-interest loans to lenders in the region.

Over the course of 2011, the high-yield corporate bond spread within the U.S. jumped by nearly 200 bps to 723 bps from 538 bps at the beginning of the year. The price to insure against default increased markedly in both North America and Europe, as measured by the Markit North American High Yield and the iTraxx European CDS series, which expanded to 6.8% and 1.7%, respectively, from 4.2% and 1%. Perhaps surprisingly, equity markets fared slightly better in 2011, with the DJIA finishing the year up 6%. Volatility in U.S. equities hit a high point shortly after Standard & Poor's downgraded the U.S., but, by the end of December, it returned to more benign levels seen earlier in the year. Still, eight more corporate entities defaulted in December, with close to half (45.3%) of all global corporate defaults occurring in the fourth quarter alone. Europe continued to make minimal progress in the beginning of 2012, with Greece selectively defaulting as any final resolution remains uncertain. 2011 may have begun favorably for investors--especially considering the gyrations of 2010--but it finished with more uncertainty for the future than it began with. The economic and financial situation is marginally better in the U.S., though uncertainty in Europe could continue, with a possible fallout globally.

Quarterly Trends

Although the total number of defaults in 2011 was lower than in 2010, fourth-quarter 2011 saw a noticeable increase relative to the prior six quarters (see chart 14). This increase stands in contrast to the five in the first quarter of the year, which was the lowest quarterly amount since the third quarter of 2007. Similarly, the volume of debt affected by defaults fell in the first quarter, to $3.8 billion, but it rose to nearly $35 billion in the fourth quarter (see chart 15). During 2011, the second quarter produced $39.5 billion in affected debt, but this was mostly attributable to Texas Competitive Electric Holdings' $32.5 billion in outstanding debt.

Chart 14

Chart 15

The 12-month-trailing and annual default rates have become industry standards, but default rates measured over shorter time frames give a more immediate picture of credit market conditions. With this in mind, based on quarterly intervals of measurement (nonannualized), default activity appears to have been on the upswing at the end of 2011, with global, U.S., and European default rates at their highest points in the year (see chart 16).

Chart 16

Lower Ratings Are Consistent With Higher Default Vulnerability

On average, there is a negative correlation between the initial rating on a firm and its time to default, if that were to occur. For example, for the entire pool of defaulters (1981-2011), the average times to default for issuers that were originally rated in the 'A' and 'B' categories were 12.6 years and 4.7 years, respectively, from initial rating (or from Dec. 31, 1980, the start date of the study), whereas issuers in the 'CCC' rating category or lower had an average time to default of only 2.5 years. In cases where an entity emerges from a prior default (including distressed exchanges), we consider it a separate entity, with the original rating as the first after the default event. Table 10 displays the median, average, and standard deviations for the time to default from the original rating. The differences between each rating category's minimum and maximum times to default are also presented in the last column under "range." Table 11 presents the average and median times to default from each rating category and includes both rating originations as well as transitions to each category. In both cases, the standard deviation of the times to default shrinks progressively as the rating gets lower. Generally speaking, the average time to default for each rating category is longer when based on the initial rating on an issuer than it is based on ratings reached later in the issuer's history. The notable exception to this is the 'AAA' category, which shows a slightly longer average time to default (see table 11), though this is a function of the small sample size. In total, seven issuers initially rated 'AAA' and another nine issuers that were rated 'AAA' at some point during their history have defaulted.

Table 10

Table 11

Table 12 shows the cumulative distribution of defaulters by timeline of default count based on the original rating on a firm. The first row is the rating distribution of defaults occurring within 12 months of the original rating. The second row is the distribution of the cumulative count of defaults occurring within three years of the original rating. In line with expectations, the majority (87.8%) of companies that defaulted within one year of the original rating are from the lowest rating categories of the speculative-grade universe. For example, of the 123 companies that defaulted within 12 months of having been rated, 109 were originally rated in the 'B' category ('B+', 'B', and 'B-') or lower. Only when looking at longer time frames do companies with higher original ratings surface among the defaulters. For example, of all the companies that defaulted during 1981-2011, only two entities rated 'AAA' at inception defaulted within seven years. Throughout the 31-year span, only seven companies initially rated 'AAA' have ever defaulted. These were Macy’s Inc., Ally Financial Inc., Ambac Assurance Corp., Mutual Benefit Life Insurance Co., Executive Life Insurance Co. CA, Confederation Life Insurance Co., and Motors Liquidation Co. (formerly known as General Motors Corp.).

Table 13 shows the cumulative defaults over various time horizons from all ratings, which includes initial ratings (see table 12), as well as from all other ratings until reaching default. Each issuer is likely to be captured multiple times, in line with its migration from one rating to another, so the total count in table 13 is different from that in table 12. From the first row of this table, we see that 10 companies rated 'A' at any point in their lifetime defaulted within one year of receiving this rating. It is important to note that in table 13, the times to default are from the date that each entity received each unique rating in its path to default. In contrast, table 21 reports transition to default rates using the static-pool methodology, which calculates movements to default from the beginning of each static-pool year. This usually leads to shorter time frames from which to calculate default statistics. Data provided in table 13 also differs from default rates provided in table 24 owing to the use of the static-pool methodology. For more information on methodologies and definitions, please see Appendix I.

Table 12

Table 13

Defaults are disproportionately from low rating categories, even during times of heightened stress (see table 14). Over longer time horizons, the same is true. For example, defaults of 371 companies were recorded in the five-year pool that began in January 2007, of which 89% were speculative grade on Jan. 1, 2007. (See table 15 for a list of the 37 publicly rated investment-grade defaults during this time period; three defaults that were confidentially rated are not listed.) Among nonfinancial entities, the lower the rating, the higher the number of defaults, and the lower the survival rates. Note that among financials, ratings are concentrated in investment grade, and the speculative-grade category accounts for no more than 20% of all ratings in the pools. For these sectors, defaults were clustered at the lower end of the investment-grade category in the three- and five-year horizons. Among the defaulters in 2011, only MF Global began the year rated investment grade. In addition, all but one of the defaulters that were rated at the beginning of the year originated in the 'B' and 'CCC/C' categories (see table 14).

Table 14

Table 15

Since 1981, the 'B' rating category ('B+', 'B', and 'B-') has accounted for 1,114 defaulters (53.9% of the total), well more than double the number of entities rated 'BB'--the nearest rating category (see tables 10 and 12). Given the historical track record, monitoring the movement in new rating patterns could prove useful in anticipating future default activity based on the notion that years characterized by high numbers of new ratings of 'B-' or lower will likely be followed by increased default risk. Chart 17 plots the ratio of all new ratings of 'B-' or lower in the U.S. to total speculative-grade ratings against the year-end U.S. speculative-grade default rate. As coincident indicators, broad movements in the two series generally mirror each other throughout most of their shared history--uncannily so in the most recent three years.

Chart 17

Industry Variations

Alongside a decrease in the number of defaults in 2011 relative to the previous year, the percentage of defaulters from the financial sector has also declined. In 2011, financial defaults accounted for 15.1% of total defaults globally, which is considerably less than the 21% share in 2010. Of the eight financial entities that defaulted in 2011, four were from New Zealand, and of these, one was placed in receivership and another under regulatory directive. These defaulters, however, were small in terms of affected debt. In fact, including all financial companies, the sector only accounted for 4.6% of the total, compared with 9.4% in 2010 and more than half of the 2008 amount.

Over the long term, cyclicality has been more pronounced in nonfinancial sectors than in financial sectors, which is to be expected in light of the differences in their rating profiles (see chart 18). Financial companies were more likely to possess an initial rating in the investment-grade category, while nonfinancials companies were more likely to have initial ratings in the speculative-grade domain. Over the 31-year period this study covers, 74.8% of financials had an initial investment-grade rating, while only 36.3% of nonfinancials did. This helps to explain the resemblance between the annual default rates of nonfinancial entities and those of the speculative-grade universe as a whole. This certainly contributes to the vast differences between cumulative default rates across financial and nonfinancial sectors (see table 16). For example, at the end of 2011, the one-year default rate among all financial entities was 0.39%, compared with 0.95% for all nonfinancials. The gap persists and even expands over longer-term horizons, such as three years and 10 years (see chart 19).

Table 16

Chart 18

Chart 19

Of the 2,068 defaults recorded globally over the long term, six sectors displayed an average time to default that is lower than the overall average of 5.8 years. These sectors are energy and natural resources, financial institutions, high technology, leisure time/media, real estate, and telecommunications (see table 17). Using the median rather than the mean adds the transportation sector into the mix.

Table 17

Table 18

Default rates by industry in 2011 were generally lower relative to their 2010 levels and to their long-term averages (see table 19). By industry, only the forest and building products/homebuilders, leisure time/media, and transportation sectors had default rates in 2011 that were higher than 2%. And only one other--the consumer/service sector--breached 1%. Expect for consumer/service, these industries often have the highest annual default rates. This is particularly true in leisure time/media and forest and building products/homebuilders, given their reliance on the economic health of consumers, which has been declining in recent years. For the second year in a row, the high technology/computers/office equipment sector had a default rate of zero. The utility and telecommunications sectors also survived 2011 without a single incidence of default. When comparing default rates across sectors, it is important to note some key differences between the various industries. Some of the variation in default rates between sectors stems from sample size differences as well as differentiation in the rating mix across industries. For example, the leisure/media sector has a much higher representation of speculative-grade ratings than the financial institutions or insurance sectors (see chart 20).

Table 19

Chart 20

Hefty Growth In Speculative-Grade Ratings

History suggests that growth in speculative-grade ratings is usually a precursor to a wave of defaults. The surge in speculative-grade originations beginning in 2002 in the U.S.--where the high-yield market has the most depth--supports this notion (see chart 23). By contrast, speculative-grade rating originations in Europe appear more subdued, but much of the leveraged activity migrated to the private credit estimate market, which is not included in this study or the CreditPro® database (see chart 24). As default rates have been falling around the globe, another increase in the proportion of speculative-grade issuers has begun, particularly in the U.S., where 51.5% of issuers are rated speculative grade as of December 2011.

This most recent default cycle was different than the previous two, which peaked in mid-1991 and mid-2002. In this latest cycle, default activity was centered on the U.S. It was also a shorter cycle when measured from the most recent trough, at the start of 2008, to the end of 2011 (see charts 22-24). This more abbreviated time frame is most likely the result of the massive interventions by central banks and governments, which were far less of a factor in the previous two cycles. On a trailing-12-month basis, the global speculative-grade default rate peaked at 10.1% in November 2009 (see chart 21). As we're past the low point for corporate financial markets, risk appetite has increased, as demonstrated by an increase in the share of new issuers rated speculative grade over the last two years, to 72.5% in 2011 and an all-time high of 79% in 2010. In addition, the total number of issuers receiving initial ratings was at its third-highest level (712) in 2011, further emphasizing a continued positive corporate credit outlook.

Chart 21

Chart 22

Chart 23

Chart 24

Transition Tables And Cumulative Default Rates

Barring the 2008 default of Lehman Brothers, the downgrade of the U.S. government on Aug. 5, 2011, had more significant repercussions for the profile of corporate issuers than any other event in recent years. With the downgrade of the U.S. to 'AA+' from 'AAA', a large number of 'AAA' rated financial institutions with ratings implicitly tied to that on the sovereign experienced downgrades to 'AA+' shortly after. Nearly as many insurance groups were downgraded to 'AA+' from 'AAA', given their large holdings of U.S. Treasuries. As a result of these downgrades, the 'AAA' stability rate for 2011 fell to 49% globally and to a meager 14.3% in the U.S. In fact, of all 'AAA' downgrades in 2011, only one was from outside the U.S.

The global pool of 'AAA' rated corporate entities (including insurance companies and financial institutions) is now roughly one-quarter of the size it was at the beginning of 2007. The economic downturn and financial crisis that began in the second half of 2007 have caused a large number of downgrades, particularly in the U.S. financial sector. Within the U.S., only four corporate entities are rated 'AAA', none of which are financial institutions or insurance companies. In contrast, 89% of 'AAA' rated companies in the U.S. at the start of 2007 belonged to one of these two sectors. In Europe, changes to our bank criteria in November produced a large number of downgrades within the 'AA' rating category (see table 20).

Barring the large number of downgrades from the highest rating categories in 2011, an analysis of transition rates over the four quarters ended December 2011 suggests that ratings behavior continues to exhibit consistency with long-term trends, showing a negative correspondence between ratings and observed frequency of default. Investment-grade-rated issuers tend to exhibit greater rating stability (as measured by the frequency of rating transition) than their speculative-grade counterparts (see table 20). For instance, 86.7% of issuers rated 'A' at the beginning of 2011 were still rated 'A' by Dec. 31, 2011, whereas the comparable share for issuers rated 'B' was only 76.3%. The same relationship holds when we analyze the transition rates separately for the U.S., Europe, and the emerging markets.

Over the long term (1981-2011) heightened ratings stability is broadly consistent with higher ratings (see table 21). A key observation when analyzing transition matrices that present averages computed over multiple static pools is that the standard deviations associated with each transition point in the matrix are large relative to the averages (outside of stability rates). This will also be applicable within the average cumulative default rate tables presented in this study. This reflects the significant variability across multiple static pools.

Table 20

This study--in line with previous default studies--confirms that over the long term (1981-2011), higher ratings are more stable than lower ratings. 'AAA' rated issuers were still rated 'AAA' one year later 87.19% of the time, and 'CCC'/'C' ratings remained 'CCC'/'C' 43.93% of the time. These long-term relationships do not change even when default rates are calculated over longer time horizons (see table 21) or are broken out by region (see table 22). In contrast, the relationship is slightly more discontinuous when we examine the rating transitions across modifiers (i.e., a plus or minus after a rating), but these variations are likely a result of sample size variations, and we do not consider them significant (see table 23). For example, 'AA+' rated issuers were still rated 'AA+' one year later 76.2% of the time, and 'AA' rated issuers were still rated 'AA' one year later 79.8% of the time.

Table 21

Table 22

Table 23

Over each time span, lower ratings correspond to higher default rates (see table 24 and chart 25). This also holds true in every region worldwide (see table 25).

Chart 25

Table 24

The only exceptions occur when the number of defaults is very small--such as among the higher rating categories--at the rating modifier level (see table 26). Investment-grade-rated issuers seldom default, so the number of defaults among these rating categories is very low. This small sample size can result in historical default rates that are counterintuitive. This does not imply, for example, that 'AAA' rated companies are more risky than 'AA+' rated companies but rather that both are very unlikely to default.

Table 25