The most over-used phrase in the capital markets in recent weeks has been “the fundamentals remain good” but it seems that that sentiment may prove dangerously complacent. Indeed, according to
Zazzarelli said last week that the rating agency’s corporate models have been predicting a rise in defaults for sometime.
“In the past month we’ve finally observed a correction in spreads and levels of risk aversion that should have happened sooner,” he said. “It’s no surprise that defaults will eventually rise. What is surprising is the extent to which the markets were caught off-side.”
According to Zazzarelli, Caa rated entities have been defaulting at a lot lower rate than the historical average because “liquidity kept afloat companies that would otherwise have defaulted”.
This in turn influenced risk perceptions of debt holders. “As in any sound portfolio strategy it is generally good to diversify risk by lowering portfolio concentration and hedging some risk, but at the same time that can allow banks to take on greater overall risk at the margin,” he said.
“The absolute amounts of debt outstanding is greater than it ever was before – yes it’s being diversified, but overall there is more of it.”
Globally, the low point in the speculative grade default rate, was seen at the end of March 1995 at 1.11%. It ranged around that low over the recent past, rising to 1.4% in June this year and 1.5% in July.
Moody’s base case forecast is for defaults to gradually rise to 3.5% by the end of July 2008 then to the historical average of 4.5% by July 2009. The pessimistic scenario sees defaults rising to the average of 4.5% a year earlier – at the end of May 2008.
In Europe, junk grade default rates tend to be significantly more volatile than their global counterparts as they are based on a much less extensive sample given the relative immaturity of the European high-yield market compared to that of North America.
Between February and April 2006 there were no defaults but since then defaults have risen to the 2.9% seen at the end of July 2007.
Moody’s base forecast is for the pace of defaults in Europe to remain little changed in the near future – at 2.7% through to July 2008 – but then rise to 3.7% by July 2009. In a worst case scenario, the rate is seen rising to 4.15% by July 2008 and 5.7% by July 2009.
“We are standing by our base line scenario [but] should the August market jitters feed into the global real economy, we would expect [defaults] to gradually pick-up in pace,” Zazzarelli said.
“But”, he added, “in the medium term a gradual but relentless pick-up in company failures towards the long-run historical average of 4.5% is almost a foregone conclusion.”