Default Rate Expected To Double In The Next Year

The days of historically low default rates are expected to go the same way as the benign credit markets—out the window. According to a recent report by ratings agency Moody’s Investors Service, the global speculative-grade bond default rate is expected to more than double over the next year.

Speculatively rated, or high-yield, debt is often the riskiest piece of a company’s capital structure. A two-fold increase in defaults would be significant, considering the fact that the past couple years have seen a historically low frequency of default incidents that continues even at this moment. Indeed, the trailing 12-month global default rate for speculative-grade entities ended August dropped from 1.5 percent to 1.4 percent, according to Moody’s.

The U.S. default rate for the same period is in tune with the global market, having also dropped from 1.5 percent to 1.4 percent, Moody’s said. The rate in the United States at the beginning of 2007 was 1.7 percent, compared to 2.0 percent in August 2006.

Such a low occurrence of defaults over the past two years is due largely to troubled companies having been able to tap the credit markets and refinance themselves out of trouble, at least temporarily. Refinancings have also allowed companies to stave off the maturation of their existing bonds, in effect allowing them to pay off their debt with more debt rather than with capital from their balance sheets.

But lenders have since tightened their belts, and companies can’t just extend a hand and expect a creditor to drop millions of dollars into it. Indeed, more than 50 planned high-yield and leveraged loan transactions have been deferred as a result of the shallow credit market, with an additional $200 million in backlogged high-yield financings tied to U.S. LBO deals that have yet to be completed, according to Moody’s.

In light of the credit crunch, Moody’s believes that the trailing 12-month global speculative-grade default rate will reach 4.1 percent by August 2008, while the U.S. default rate is forecast to come in a little higher at 4.5 percent.

While those default projections do represent a significant jump over the previous two years, they are not indicative of a full-fledged economic downturn. According to Standard & Poor’s, a rival ratings agency, the long-term average default rate, between the years 1981 and 2006, has been 4.5 percent.

Only 13 Moody’s-rated issuers have defaulted so far this year, affecting $4.1 billion in bonds. Last month, publicly-traded air conditioner maker Fedders North America (Nasdaq:FJCC) was the only company to do so, having filed for Chapter 11 bankruptcy after defaulting on $155 million in bonds.

Also in August, Willis Stein & Partners-owned Ziff-Davis Media Inc. elected not to make its August 15 interest payment on its senior subordinated notes due 2009. However, the consumer technology-focused media company has a 30-day grace period to make the payment before it is defined as a default. For the six months ended June 30, 2007, Ziff-Davis reported a net loss of $77.5 million, compared to a net loss of $66.5 million for the same period the year before.

Private equity-owned companies that have defaulted this year include Insight Health Services Corp. (owned by J.W. Childs Associates and The Halifax Group); Port Townsend Paper Corp. (Northwest Capital Appreciation); Remy International (Court Square Capital Partners); TK Aluminum Ltd. (AIG Global Investment Corp., CCMP Capital, Private Equity Partners SGR, and Questor Management); and The Wornick Co. (Veritas Capital).

Meanwhile, there were at least 29 other private equity-owned businesses with speculative corporate credit ratings of ‘B-’ or lower with negative implications that were at risk of default as of the end of July, according to S&P, which refers to these companies as “Weakest Links.” Negative implications indicate the ratings agency’s belief that a further downgrade is likely. According to S&P, between 1981 and 2006, 10 percent of all entities rated ‘B-‘ have ended up in default within a year of attaining that rating. Moreover, 26 percent of all ‘CCC+’ or lower rated entities have made the transition to default within a year after attaining that rating.

Among the GP-backed companies that fell into the Weakest Link category in July was Maax Holdings Inc., a J.W. Childs Associates-owned manufacturer of bathroom products and spas for the residential housing market. An uncooperative housing market no doubt has hurt the ‘CCC-’-rated company’s net sales, which for the first quarter of the company’s fiscal 2008 (ended May 31, 2007) fell 16.6 percent to $111.6 million, down from $133.9 million for the first quarter of FY 2007. Meanwhile, the company’s operating income for the first quarter of FY 2008 fell by $5.7 million, or 71 percent, from $8.1 million in the first quarter of FY 2007 to $2.4 million in the first quarter of FY 2008. J.W. Childs declined to comment for this story.

Great Hill Partners portfolio company Haights Cross Communications Inc., an education publisher, made the list thanks in part to its ‘CCC+’ corporate credit rating, which it attained in Dec. 2006. Haights Cross reported a net loss of about $27.0 million for the six month period ended June 30, 2007, compared with a net loss of $41.2 million for the same period in 2006. Meanwhile, Haights Cross’s full-year 2006 saw a net loss of $73.0 million, compared with a net loss of $32.0 million in 2005. Calls to Great Hill were not returned by press time.

Castle Harlan-owned lawn and garden tool maker Ames True Temper—rated ‘CCC+’— is another company that made the list. The New York firm acquired Ames True Temper in July 2004 for $380 million. The company’s net income for the quarter ended June 30 fell to $1.7 million, down from $7.6 million a year before. Castle Harlan declined to comment for this story through a spokesman.

While the extent to which the economy gives way to the woes in the credit market is uncertain, it is highly likely that the heavy leverage a number of companies took on over the past two years will prove too much to keep some of them afloat. —A.N.