Global Weakest Links And Default Rates: An Uptick In Weakest Links

The number of global weakest links increased to 125 on March 16 from 123 on Feb. 17. Weakest links are issuers rated 'B-' and lower with either negative outlooks or ratings on CreditWatch with negative implications. The 125 weakest links have total rated debt worth $199.1 billion.

In 2012, 23 issuers so far have defaulted (through March 16), including confidential entities. These defaulted issuers have outstanding debt worth $24.4 billion. In 2011, 53 defaulted issuers had combined outstanding debt worth $87.7 billion. By comparison, 82 issuers defaulted on debt worth $97.5 billion in 2010, and 264 issuers defaulted on debt worth $627.7 billion in 2009.

A majority of the weakest links based in Greece are banks. On Feb. 27, 2012, Standard & Poor's Ratings Services lowered its 'CC' long-term and 'C' short-term sovereign credit ratings on the Hellenic Republic (Greece) to 'SD' (selective default), following the Greek government's retroactive insertion of collective action clauses (CACs) in the documentation of certain series of its sovereign debt on Feb. 23, 2012. In our opinion, Greece's retroactive insertion of CACs materially changes the original terms of the affected debt and constitutes the launch of what we consider to be a distressed debt restructuring (for more information see, "Research Update: Greece Ratings Lowered To 'SD' (Selective Default)," published Feb. 27, 2012, on RatingsDirect).

The highlights from this month's report are:

• The 12-month-trailing global corporate speculative-grade default rate increased to 2.2% in February from 2.13% in January. Regionally, the U.S. corporate speculative-grade corporate default rate dipped slightly to 2.42% from 2.43%, while the European default rate rose to 2.33% from 2%. The default rate in the emerging markets also increased to 1.02% from 0.88%.
• The U.S. has the highest number of weakest links with 75, or 60% of the global total. By sector, media and entertainment, banks, forest products and building materials, and consumer products have the greatest concentrations of weakest links.
• The U.S. economy grew at an annualized rate of 3% in the fourth quarter. In the third quarter, real GDP grew by 1.8%. In view of a slow recovery, the Fed announced that it expects short-term interest rates to stay near zero until late 2014, longer than the mid-2013 timeline it previously announced.
• In the U.S., 39 new speculative-grade deals came to market in March 2012 (through March 16), following 49 deals in February and 32 deals in January.
• The U.S. speculative-grade spread started increasing at the beginning of August because of growing uncertainty in the global financial markets and peaked at 830 basis points (bps) on Oct. 4. Since then, the spread has been falling gradually. They fell to 626 bps at the end of February and declined further to 616 bps as of March 13, 2012.
• Our baseline forecast (with a 60% probability) is for a 12-month-forward (December 2012) corporate speculative-grade default rate of 3.3% in the U.S. (see chart 4). To realize the mean baseline projection, a total of 51 speculative-grade-rated issuers would need to default in the next 12 months. This implies an average of about 4.25 defaults per month, higher than the average of about 2.3 defaults per month in the last 12 months. (For more details, see, "Default, Transition, and Recovery: The U.S. Corporate Default Rate Is Forecasted To Rise To 3.3% In 2012," published Feb. 2, 2012.)
• Our alternative default-rate forecasts are 5.3% for the pessimistic scenario and 1.8% for the optimistic scenario. From January 2012 to December 2012, 81 issuers would have to default to reach the pessimistic default-rate forecast, and 28 issuers would have to default to reach the optimistic forecast.
• The 12-month-trailing default rate for U.S. leveraged loans (based on the number of loans) increased slightly to 0.62% in February from 0.61% in January.

Monthly Movements In Default Rates

Globally, the 12-month-trailing corporate speculative-grade default rate increased in February to 2.2% from 2.13% in January (chart 1). In the U.S., the corporate speculative-grade default rate declined slightly to 2.42% from 2.43%. The European speculative-grade default rate rose to 2.33% from 2%, and the emerging markets default rate increased to 1.02% from 0.88%.

Table 1

Chart 1

The general decline in default rates since November 2010 reflects an improvement in the credit markets. Nonetheless, the transportation, forest and building products/homebuilders, and insurance sectors have significantly higher default rates than other sectors (see table 2). These sectors' results reflect a slow recovery, the sectors' cyclicality, and dependence on various macroeconomic developments.

Table 2

In 2012 (through March 16), global corporate defaults, including confidential defaulters, totaled 23 and accounted for $24.4 billion in debt (see table 3). In comparison, in 2011, 53 seven entities defaulted, amounting to $84.3 billion, and 82 issuers defaulted in 2010 with debt of $97.5 billion--down from 264 defaulters in 2009 ($627.7 billion in debt) and 126 defaulters in 2008 ($432 billion).

Five entities have defaulted since our most recent weakest links report (through March 16):

• On Feb. 22, 2012, Standard & Poor's lowered its long-term corporate credit ratings on Ireland-based telecom player ERC Ireland Preferred Equity Ltd. (ERCIPE) to 'SD' from 'CC'. The rating action on ERCIPE followed delays in making the coupon payment on its €350 million floating-rate notes for more than five business days after the scheduled due date on Feb. 15, 2012. As per our criteria, we consider the extension of a payment maturity as tantamount to a default if the payment falls later than five business days after the scheduled due date. This is regardless of any grace period stipulated in the indenture. However, the parent, Eircom Group, is in the process of restructuring its balance sheet. (For more details, see "Research Update: Ireland-Based ERC Ireland Holdings Long-Term Corporate Credit Rating Lowered To 'SD' On Missed Coupon Payment On FRNs," published on Feb. 22, 2012.)

• On Feb. 27, 2012, Standard & Poor's lowered its ratings on Japan-based semiconductor manufacturer Elpida Memory Inc. to 'D' from NR. Prior to be the withdrawal of ratings, the entity was rated 'B+'.

• On March 1, 2012, Standard & Poor's lowered its corporate credit rating on Brazil-based electricity distributor Centrais Eletricas do Para S.A. (Celpa) to 'D' from 'CCC+'. The downgrade of Celpa followed its judicial reorganization filing. The event increased the refinancing risk of other Rede Energia Group's subsidiaries, Centrais Eletricas Matogrossenses S.A. and Companhia de Energia Eletrica do Estado do Tocantins. Celpa has struggled to improve its business risk profile, which has been vulnerable for the past few. (For more details, see "Research Update: Centrais Eletricas do Pará Downgraded To 'D', Two Other Rede Energia Subs Ratings Cut To 'CCC' And Placed On Watch," published on March 1, 2012.)

• On March 2, 2012, Standard & Poor's lowered its corporate credit rating on U.S.-based gaming operator Circus and Eldorado Joint Venture (CEJV) and its issue-level rating on CEJV's mortgage notes to 'D' from 'CCC-'. The downgrade of CEJV follows its inability to successfully repay the principal on its mortgage notes, which was due on March 1, 2012. CEJV has been in discussion with potential financing sources and the holders of the mortgage notes for a possible restructuring of the obligations under the notes and has entered into a forbearance agreement with a substantial holder of the outstanding notes. (For more details, see "Research Update: Circus And Eldorado Joint Venture Ratings Lowered To 'D' From 'CCC-' After Failing To Pay Mortgage Principal," published on March 2, 2012.)

• On March 7, 2012, Standard & Poor's lowered its issuer credit rating on U.S.-based gaming company Mohegan Tribal Gaming Authority (MTGA) to 'SD' from 'CC'. At the same time, Standard & Poor's lowered the issue-level ratings on MTGA's existing credit facility, senior notes, and senior subordinated notes to 'D' from 'CC'. The rating actions follow the MTGA's announcement of the final results and settlement of the exchange offers and the amendment and restatement of the credit facility. Approximately $962 million in aggregate principal out of $1.075 billion in outstanding principal of existing notes were validly tendered and not withdrawn. In our view, the exchange offers and the extension of MTGA's bank facility are a de facto restructuring and, thus, are tantamount to a default according to our criteria. (For more details, see "Research Update: Mohegan Tribal Gaming Authority Downgraded To 'SD' On Settlement Of Exchange; Participating Debt To 'D'," published on March, 7, 2012.)

Table 3

In the leveraged loan segment, Standard & Poor's LCD reported that the 12-month-trailing institutional loan default rate (based on the number of loans) was 0.62% in February, a slight rise from the previous month, but down significantly from 0.92% in October 2011. The leveraged loan default rate has declined significantly since 2009 because of the stabilization of the credit markets and increased economic activity. The loan distress ratio (defined as the percentage of loans trading below 80 cents on the dollar) decreased to 5.23% in February from 5.8% in January (see chart 2).

Chart 2

This Month's Weakest Links

The number of global weakest links increased to 125 as of March 16 from 123 in the previous month and 108 a year ago. Many weakest links have already defaulted, and we expect that a large proportion of the defaults in the next few quarters will come from this group. The 125 weakest links account for a total of $199.1 billion in debt. Negative outlooks and ratings on CreditWatch negative are good leading indicators of actual downgrades. Relative to all speculative-grade-rated entities, weakest links account for a large proportion of defaults, particularly during periods of economic stress. During the 2001 to 2002 downturn, more than half of the weakest links defaulted within 12 months, and nearly 65% defaulted within three years. By contrast, about 10% of all speculative-grade-rated entities defaulted within 12 months, and about 23% defaulted within three years. The 36-month-trailing weakest links default rate continued to climb, reaching 58% in March 2011, while the 12-month weakest links default rate has already declined significantly to 18% from a high of 43% in September 2009. In any given one- or three-year period since 1999, the proportion of weakest-link defaulters was always higher than the proportion of defaulters from the entire speculative-grade pool. For the trailing 36 months, the weakest links default rate was, on average, 2.2x higher than for all speculative-grade-rated issuers from 1999 to 2011 and 6.4x higher than the speculative-grade default rate at the end of 2007. (For more details, see "Most Of The Global Defaulters In 2011 Were Weakest Links," published Jan. 20, 2012.)

The number of weakest links has declined significantly from the record high of 300 in April 2009, when the credit markets were much more volatile. The weakest links are the lowest-rated entities, so it is no surprise that many of the companies that have defaulted were weakest links. During the 2001 recession, the sharp rise in defaults accompanied the rise in weakest links. More recently, for publicly rated companies, weakest links represented 97 of the 105 defaulted companies in 2008, 218 of the 236 defaulted companies in 2009, 59 of the 70 defaulted companies in 2010, and 41 of the 53 defaulted companies in 2011. In 2012, 18 of the 20 defaults (excluding confidential entities) were prior weakest links.

Since our most recent report, we removed eight entities from our list of weakest links and added 10 others. Five of the eight entities that we removed from the list were U.S. entities, and the remaining three entities were from Europe. We removed the following entities from the list:

• NCO Group Inc. and Central Parking Corp. after we placed the ratings on these companies on CreditWatch with positive implications;
• Gentiva Health Services Inc., FCC Holdings LLC, and Norske Skogindustrier ASA after we revised the outlooks on these companies to stable;
• Lantiq Beteiligungs-GmbH & Co. KG after we revised its outlook to positive;
• ERC Ireland Preferred Equity Ltd. and Mohegan Tribal Gaming Authority after we downgraded these companies to 'SD'.

We added the following entities to the weakest link list:

• Companhia de Energia Eletrica do Estado do Tocantins and Centrais Eletricas Matogrossenses S.A. after Standard & Poor's downgraded them to 'CCC' and placed the ratings on the companies on CreditWatch with negative implications;
• Midwest Vanadium Pty Ltd. and Xinergy Corp. after Standard & Poor's placed the ratings on the companies on CreditWatch with negative implications;
• A.T.U. Auto-Teile-Unger Holding GmbH, Stanadyne Holdings Inc., and SAS AB after we revised their outlooks to negative;
• CMA CGM S.A., FriendFinder Networks Inc., and Willbros Group Inc. after Standard & Poor's downgraded the companies to 'B-'.

Of the 10 new weakest links, four are from the U.S., three are from Europe, two are from Latin America, and one is from Asia-Pacific region.

Based on the number of weakest links, we believe that the media and entertainment, banks, forest products and building materials, and consumer products sectors are most vulnerable to default (see chart 3). The media and entertainment sector has the greatest number of weakest links with 30 entities, or 24% of the total. The bank sector has the second most weakest links with 12, followed by the forest products and building materials sector, which has nine weakest links.

Chart 3

U.S.-based issuers (a category in which we include issuers in tax havens such as Bermuda and the Cayman Islands) account for 60% of the 125 weakest links (see table 4). This preponderance is partially due to the fact that a large proportion of issuers Standard & Poor's rates are in the U.S. By volume, the 75 U.S.-based weakest links account for about $135.3 billion of debt, which is 68% of the total of $199.1 billion for all weakest links.

Table 4

U.S. Speculative-Grade Default Forecast

Our baseline forecast (with a 60% probability) is for a 12-month-forward (December 2012) corporate speculative-grade default rate of 3.3% in the U.S. To realize the mean baseline projection, a total of 51 speculative-grade-rated issuers would need to default in the next 12 months. This implies an average of about 4.25 defaults per month, higher than the average of about 2.4 defaults per month in the last 12 months.

Chart 4

Standard & Poor's expects the U.S. corporate 12-month speculative-grade default rate to rise to 3.3% by December 2012 from 1.98% in December 2011. Our baseline projection is still lower than the long-term (1981-2011) average of 4.5%. Five U.S. speculative-grade companies defaulted as of Jan. 31, 2012, bringing the default rate up to an estimated 2.4%. In 2011, 29 speculative-grade issuers defaulted during the 12 months ended December 2011--12 in the fourth quarter.

In addition to our baseline projection, we forecast the default rate in our optimistic and pessimistic scenarios. Our optimistic default rate forecast assumes that the U.S. economy and financial markets perform better than expected. As a result, we would anticipate the default rate to be just below the current level of 1.8% by December 2012 (or 28 defaults during the 12-month period). On the other hand, a financial collapse and a deep recession in Europe could lead to another recession in the U.S. Under this pessimistic scenario, we would expect the default rate to be 5.3% (or 81 defaults during the 12-month period). We base our forecasts on quantitative and qualitative factors, including, but not limited to, Standard & Poor's proprietary default model for the U.S. corporate speculative-grade bond market. We update our outlook for the U.S. issuer-based corporate speculative-grade default rate each quarter after analyzing the latest economic data and expectations.

The increased momentum of the U.S. economic recovery has reduced the risk of another recession. The labor market is improving, businesses appear to have more confidence, which has led to greater investment and increased hiring, and consumers are spending a little bit more. However, as we learned last year, this stronger showing of the economy may not be a reliable indicator of a strong economy for the remainder of the year. Strong headwinds remain, and volatility continues to characterize the recovery. While the risk of another recession has declined, it could still occur, predominantly as a result of Europe's unresolved financial issues. Moreover, the markets remain concerned about increased regulation in the U.S., the still excessive housing supply, and the government's austerity measures, which may impede the recovery (see "Default, Transition, and Recovery: The U.S. Corporate Default Rate Is Forecasted To Rise To 3.3% In 2012," published Feb. 2, 2012).

Macroeconomic Sources Of Default Rates

The U.S. speculative-grade spread started increasing at the beginning of August because of the growing uncertainty in the global financial markets and peaked at 830 bps on Oct. 4. The spread declined through October, but increased gradually in November to finish the month at 740 bps and again started falling through January. On March 13, the U.S. speculative-grade spread was 616 bps, compared with 497 bps a year ago. The U.S. corporate investment-grade spread declined slightly to 201 bps as of March 13 from 200 bps as of Feb. 29, 2012, compared with 165 bps as of March 14, 2011. Bond spreads naturally correlate with Standard & Poor's U.S. distress ratio, and the distress ratio typically reflects the movements in spreads. As of Feb. 15, 2012, 13.2% of all U.S. corporate speculative-grade issues were trading at distressed levels (see chart 5). The distress ratio was 15.3% in January, 16.6% in December, and an all-time high of 85% in December 2008.

Table 5

Chart 5

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.

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 leading sectors of distress as of Feb. 15 were diversified and transportation, which had distress ratios of 50% and 26.5%, respectively. However, when combined, these sectors had only 10 distressed issues. The media and entertainment sector came in third with a distress ratio of 22.6%, and aerospace and defense followed with a distress ratio of 17.9%.

Additionally, 10 sectors have experienced an increase in their proportions of total distressed issuers since January, while nine sectors have experienced a decrease. The sector with the largest decrease in its proportion of the total was chemicals, packaging, and environmental services, which fell by 3.1% month over month to 2%. Following closely behind was the high technology sector, which had its proportion of total distressed issues decline by 3% from last month (see "Credit Trends: Distressed Debt Monitor: The U.S. Distress Ratio Falls To 13.2% In February," published Feb. 23, 2012.)

The U.S. economy grew at an annualized rate of 3% in the fourth quarter. In the third quarter, real GDP grew by 1.8%. Our economists expect real GDP in the U.S. to grow 2.1% in 2012 and no growth in the eurozone. Industrial production was unchanged in February after having risen 0.4% in January.

The unemployment rate remained unchanged at 8.3% in February compared with the previous month (see chart 6). The unemployment rate historically is a lagging indicator, and we expect that it will remain elevated in the coming quarters. According to the Bureau of Labor Statistics, nonfarm payroll employment increased by 227,000 in February, after the data for January and December were upwardly revised to 284,000 and 223,000, respectively (previously, there were 243,000 additions in January and 203,000 additions in December). We anticipate that the labor market will remain weak, and we forecast an unemployment rate of 8.2% for 2012 (see "Economic Research: U.S. Economic Forecast: An Apple A Day Keeps Recessions Away," published March 15, 2012).

Chart 6

The U.S. manufacturing sector expanded for the 31st consecutive month in February, according to the Institute for Supply Management (ISM). ISM's manufacturing index declined 1.7 points to 52.4 points in February from 54.1 points in January. However, the reading is lower than the 12-month-high of 59.9 points. Nonetheless, the index has remained above the 50-point threshold, which indicates unchanged activity. The new order index also declined, by 2.7 points to 54.9 points in February, and the delivery index plunged by 4.6 points to 49.0. Likewise, the production index declined marginally by 0.4 points to 55.3. However, exports expanded by 4.5 points, and imports increased by 1.5 points.

Eurozone GDP contracted 0.3% in the fourth quarter, following growth of just 0.1% in the third quarter of 2011. The eurozone unemployment rate increased to 10.7% in January from 10.6% in December. Eurozone industrial production increased by 0.2% in January, following a decline of 1.1% in December (see chart 7). The eurozone purchasing managers' index for the manufacturing sector reached a five-month high, increasing by 0.2 percentage points to 49.0 in February from 48.8 points in January, showing slight improvement in economic activities amid looming debt crisis and recession in the region. Our economists expect a mild recession in the eurozone in the first half of 2012, followed by a modest pick up in the second half of the year. (For more details, see "Assessing The Severity Of The Eurozone Recession Is A Close Call," published Feb. 2, 2012.)

Chart 7

Monitoring The Pipeline Of Low-Rated Issuance Activity

In March (through March 16), a total of 51 deals (worth $25.6 billion) came to market globally. In comparison, during 2011, a total of 639 (worth $302.2 billion) new speculative-grade deals came to market, versus 755 deals (worth $345.3 billion) in 2010. New speculative-grade issuance totaled $203 billion in 2009 and $56 billion in 2008. In the U.S., 39 new speculative-grade deals came to market in March 2012 (through March 16), following 49 deals in February 2012 and 32 deals in January 2012. The dollar volume of new issuance was $18.5 billion in March (through March 16) and $28.7 billion in February 2012. During 2011, a total of 402 (worth $185.3 billion) new speculative-grade issuance came to the market. In the first three months of 2012, a total of 120 new issuances came to the market in U.S. worth $61.6 billion. By comparison, there were 307 new speculative-grade deals (worth $134.3 billion) in the first half of 2011 and 95 ($51 billion) in the second half of 2011. Overall, 511 new U.S. speculative-grade deals came to market in 2010, accounting for $223 billion in debt, compared with only 313 ($132 billion) in 2009 and 104 ($39 billion) in 2008.

New issues Standard & Poor's rates 'B-' or lower in the trailing six months as a proportion of total speculative-grade issuance were 17.05% in February, marginally down from 18.6% in January (see chart 8). In February, 27.1% of the new speculative-grade deals that came to market were rated 'B-' or lower. On an annual basis, this ratio was 34.8% in 2011, 28.4% in 2010, 21.4% in 2009, and 17.3% in 2008.

Chart 8

In Europe, speculative-grade issuance activity has risen after remaining extremely low in the last quarter of 2011. Speculative-grade issuance deals totaled seven in the last quarter of 2011 and 42 in the first three months of 2012 (through March 16). There were 15 new speculative-grade issuance in January, 23 deals in February, and four in March (through March 16) 2012. By comparison, new deals totaled 98 (worth $51.6 billion) in the first half of 2011 and just 15 (worth $7.6 billion) in the second half of 2011.

We closely monitor issues Standard & Poor's rates 'B-' and lower because these demonstrate, in our view, investors' appetite (or lack thereof) for absorbing riskier assets. Entities rated at this end of the spectrum are usually more prone to defaulting and are often the first to lose access to financing when market liquidity recedes. Low-rated issuance from 2003-2007 has been a source of defaults in recent quarters. We expect this pool of issuers to potentially experience more defaults in 2012. Over the long term (1981-2011), an average of 8.64% of all global entities Standard & Poor's rates 'B-' defaulted within 12 months, and the average default rate was much higher for entities rated lower than 'B-' (see table 6). The average 12-month transition to default declines as we move higher on the rating scale (for example, 2.5% for entities rated 'B+', 1.23% for entities rated 'BB-'). The previous spike in issuance fir these speculative-grade rating categories from 1997-1999 led to an increase in defaults in 2001 (see chart 9). During this period, the share of speculative-grade-rated companies with issues rated 'B-' or lower consistently exceeded 30%. The increase of issues rated 'B-' and lower from 2003-2007 was an early warning of the credit deterioration and default risk in 2008 and 2009.

Table 6

Table 7

Related Criteria And Research

• Credit Trends: Distressed Debt Monitor: The U.S. Distress Ratio Falls To 13.2% In February, Feb. 23, 2012
• U.S. Economic Forecast: Recovery Warms Up In January, Feb. 10, 2012
• Default, Transition, and Recovery: The U.S. Corporate Default Rate Is Forecasted To Rise To 3.3% In 2012, Feb. 2, 2012
• A Diverging And Volatile World Economy Will Influence Growth For The Gulf In 2012, Jan. 23, 2012
• Most Of The Global Defaulters In 2011 Were Weakest Links, Jan. 20, 2012