Moody's Sees Surge in High-Yield Defaults

The rate could quadruple to 4.2% next year, the agency says.
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Global default rates by speculative-grade companies are expected to quadruple to 4.2% next year, Moody's says in a new report, offering a fresh sign that easy credit fueled excessive borrowing by risky companies over the past two years.

To date this year, defaults remain low, at just 1% in November, the ratings agency says. This is the lowest level since December 1981, when it stood at 0.7%. A year ago, the rate was 1.9%.

"Our baseline forecast incorporates a slowing U.S. economy in 2008 but no recession," says Kenneth Emery, Moody's director of corporate default research. "If a recession were to materialize, default rates could increase to near double-digit levels."

The last time default rates hit double digits was in 2002, when they were around 11%.

Numerous factors are contributing to the rising levels of distressed situations. The environment has been very forgiving for debtors in recent years, but credit markets have quickly tightened. A large chunk of lower-quality debt was issued by LBO firms for buyout deals of public companies.

"The main reason for the big increase

in expected defaults is the very poor quality of new issues in the high-yield market in 2006 and the first half of 2007," says Edward Altman, professor of finance at New York University Stern School of Business and an expert on corporate bankruptcy. Altman had forecast earlier this year that default rates would rise to around 4% in 2008.

About 48% of new high-yield bond issues in 2007 were rated B-minus or below (the bad cohort), Altman says, and it has now become more difficult for truly distressed firms to refinance as liquidity has dried up.

Several sectors have multiple restructuring candidates: subprime and housing-related; discretionary consumer; paper, packaging and plastic; and health care, according to a recent presentation by Barry Ridings, co-head of restructuring at Lazard.

Lazard was hired earlier this year by two troubled homebuilders --

Tarragon

(TARR)

and TOUSA, which now trades on the pink sheets after it said it may be forced to file for Chapter 11. Certain industry analysts point to

Standard Pacific

(SPF)

and

WCI Communities

(WCI)

as other homebuilders facing significant distress.

The decreasing quality of debt issued by companies is particularly striking. Leverage multiples are rising, and there is a high percentage of debt rated B and worse. Last year, global high-yield issuances rose to $238 billion from $188 billion the year prior, according to Thomson Financial. A larger chunk of last year's product was rated CCC at issuance than in 2005.

In October of this year, the average debt-to-EBITDA multiples for companies reached 5.2 times, up from 4.4 times in 2006, according to Standard & Poor's.

Moody's says that in November there was only a single default among its rated corporate issuers: American Color Graphics, a printing and publishing company based in Tennessee.

During November, note holders representing more than 92.5% of the company's $280 million senior second secured notes agreed to defer the 10% semi-interest payment due Dec. 15 for three months, Moody's said.

But essentially, any company with a rating of Caa1 by Moody's is a prime candidate for default, says Emery, the firm's director of corporate default research.

Year to date, 17 Moody's-rated issuers have defaulted, fewer than the 29 defaults in the comparable period in 2006.