Junk Bond Stress at Record Low as Defaults Slow: Credit Markets

Junk bond investment 30 percent higher than 2011.

 Aug. 7 (Bloomberg) -- U.S. speculative-grade companies are in the best position ever to meet their debt obligations as investors pour a record $43 billion into high-yield mutual funds and borrowers boost the cash held on balance sheets.

Moody’s Investors Service said Aug. 1 its Speculative-Grade Liquidity-Stress index, which falls as corporations’ ability to manage cash needs improves, dropped to 3.1 percent in July, beating the previous record low of 3.3 percent in May. The New York-based ratings firm sees the U.S. default rate peaking at 4 percent in October before falling to 3 percent by June 2013, below the historical average of 4.6 percent since 1992.

While the unemployment rate has held above 8 percent since February 2009, demand for high-yield, high-risk bonds has grown as investors speculate that the Federal Reserve will keep interest rates near zero through late 2014 to bolster the economic recovery. Credit Suisse Group AG boosted its forecast for returns this year to a range of 8 percent to 11 percent from 7 percent to 10 percent.

“The access to the market is mainly a function of a lot of demand for yield, but investors would not buy with the same enthusiasm if they really thought there were credit problems looming,” Martin Fridson, global credit strategist at BNP Paribas Investment Partners in New York, said in a telephone interview. “The companies are genuinely in good shape.”

Opportunistic Issuance

Junk-bond funds received $9.32 billion of inflows in July, the most since February, sending the 2012 total 30 percent higher than the previous full-year record, according to EPFR Global in Cambridge, Massachusetts. High-yield companies may face tougher borrowing conditions if European policy makers fail to curb soaring yields and the U.S. economy weakens, Moody’s said in the Aug. 1 report.

“Liquidity in the market, just in general, it can change on a dime,” Scott Roth, U.S. high-yield fund manager in Springfield, Massachusetts at Babson Capital Management LLC, which oversees $149 billion in assets, said in a telephone interview. “There will be times where it will be difficult to finance, and I think that’s why when the market is open for business, which it is right now, companies will need to be opportunistic.”

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. fell for a third day, with the Markit CDX North America Investment Grade Index of credit-default swaps, which investors use to hedge against losses or to speculate on creditworthiness, declining 0.5 basis point to a mid-price of 102.2 basis points as of 11:09 a.m. in New York, according to prices compiled by Bloomberg.

 Swap Spreads

 The measure typically falls as investor confidence improves and rises as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

 The U.S. two-year interest-rate swap spread, a measure of debt market stress, decreased 0.38 basis point to 19.01 basis points as of 11:10 a.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

 Bonds of Newark, New Jersey-based Prudential Financial Inc. were the most actively traded dollar-denominated corporate securities by dealers, with 120 trades of $1 million or more as of 11:11 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The second-biggest U.S. life insurer sold $1 billion of 5.875 percent, 30-year fixed-to-floating rate debt yesterday. The securities rose 2.1 cents from the sale price to 102.1 cents on the dollar for a yield of 5.6 percent as of 11:36 a.m. in New York, Trace data show.

Record Low

The record low on Moody’s liquidity-stress index follows a decline in the number of companies with liquidity ratings of SGL-4, the lowest speculative-grade level, to the fewest since November 2005, Moody’s analysts Tom Marshella, Keith Foley, John Puchalla and Adam McLaren wrote in the report.

While two companies, Patriot Coal Corp. and Cinram International Inc. had their ratings withdrawn after filing for bankruptcy, Casella Waste Systems Inc. and GeoEye Inc. had their liquidity grades raised to SGL-3.

Free cash-flow at Rutland, Vermont-based Casella rose to $3.6 million in the fiscal quarter ended April 30, compared with negative cash flow of $23.4 million a year earlier. Free cash flow at GeoEye, the company being purchased by DigitalGlobe Inc., narrowed to negative $16.4 million in the first quarter of 2012 from negative $53.3 million a year earlier, Bloomberg data show.

Cash Flow

“Over the past couple of years, since the worst part of the downturn, cash flow has generally been improving,” Puchalla said in a telephone interview. “Our forecast for the default rate is that it will remain relatively low by historical standards over the next year, and it gives investors some comfort, at least in the near term, investing in higher yielding bonds.”

The index is calculated by dividing the number of companies rated SGL-4 by the total number in the index. When the number of companies assigned the lowest speculative-grade liquidity ranking falls, the measure also declines. The gauge has plunged from a high of 20.9 percent in March 2009.

The trailing 12-month default rate for global speculative- grade companies was 2.7 percent at the end of the second quarter, 2.1 percentage points below the historical average of 4.8 percent, according to a July 10 report from Moody’s.

High-risk, high-yield bonds are rated below Baa3 by Moody’s and lower than BBB- by Standard & Poor’s.

Junk Returns

Speculative grade bonds have returned 9.66 percent this year, including reinvested interest, Bank of America Merrill Lynch indexes show, compared with 8.99 percent for the Dow Jones Industrial Average when including dividends.

“Just with the dearth of yield out there, there continues to be a high level of demand” for riskier securities, Brian Nold, senior high-yield portfolio manager at Seix Investment Advisors LLC and sub-adviser of the RidgeWorth Seix High Yield Fund, said in a telephone interview. “It’s created the opportunity for companies to come to the market and access the capital markets.”

U.S. junk-bond issuance rose to $22.2 billion last month, the most since April, Bloomberg data show. Sales this year have totaled $174.3 billion.

 The increased demand for riskier assets has driven down yields on junk-rated debt to within 30 basis points of the all- time low. Yields dropped to 7.45 percent yesterday, compared with a record low of 7.19 percent set on May 19, 2011, according to the Bank of America Merrill Lynch U.S. High-Yield Master II bond index.

Market Volatility

While high-yield companies are benefiting from those lower rates, they aren’t doing so recklessly, and that has boosted their appeal as Europe’s strains and a weakening global economy increase volatility in financial markets, according to Eric Takaha, a director of corporate and high-yield debt for Franklin Templeton’s fixed-income group that manages more than $350 billion.

“They’ve taken advantage of the strong demand, but I think the fact is that they haven’t really been as aggressive with their balance sheets as they could have been given the amount of money flowing into the asset class,” he said in a telephone interview from San Mateo, California.

While high-yield liquidity is healthy, borrowers rated B3 or less may find it difficult to refinance their debt because access to credit markets has diminished for lower quality companies, Moody’s analysts led by Kevin Cassidy wrote in a Aug. 6 report. The 25 largest companies with “high credit risk” as defined by Moody’s hold $74 billion of junk debt maturing between 2012 and 2016, according to the report.

“The lower a company’s credit rating, the more difficult it will likely be for it to refinance at manageable rates,” the analysts wrote.

Funding Risks

Companies including Clear Channel Communications Inc., Texas Competitive Electric Holdings Co. and Caesars Entertainment Corp. may need to restructure, particularly if businesses don’t improve. European sovereign debt concerns and a slowing U.S. economy could further impede access to funding, according to Moody’s.

“There will always be some issuers that would face difficulty refinancing near-term maturities,” Puchalla of Moody’s said. The “bigger picture is that companies on balance have been able to proactively address their maturities. So at least for the next 12 to 15 months, they don’t seem to be a widespread problem.”

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About the Author

Brooke Sutherland

Brooke Sutherland

Brooke Sutherland covers industrials and M&A for Bloomberg Gadfly. You can find her on Twitter: @blsuth

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