'Spike In Defaults': Standard & Poor's Gets Gloomy, Blames Fed

by: Wolf Richter

“Hangover from years of lenient credit may become painful.”

Credit rating agencies, such as Standard & Poor's, are not known for early warnings. They're mired in conflicts of interest and reluctant to cut ratings for fear of losing clients. When they finally do warn, it's late and it's feeble, and the problem is already here and it's big.

So Standard & Poor's, via a report by S&P Capital IQ, just warned about US corporate borrowers' average credit rating, which at "BB," and thus in junk territory, hit a record low, even "below the average we recorded in the aftermath of the 2008-2009 credit crisis."

The one-year average default rate for US companies with a credit rating of B- is 9.8%, according to Standard & Poor's. That's a 1-in-10 chance that the company will default over the next 12 months. Companies getting downgraded deep into junk and issuing more low-grade bonds are precursors to soaring defaults.

The signs have been piling up. S&P Capital IQ:

In 2015, Standard & Poor's downgraded 5.54% of the U.S. speculative-grade nonfinancial corporate borrowers it rates - the highest level since 2009.

The average credit rating for U.S. nonfinancial corporate issuers has fallen to a record low due to the continued rapid rise in lower-quality borrowers.

As a result, nonfinancial corporate borrowers' net negative bias is at a post-recession high and the speculative-grade downgrade rate is at the highest level since 2009.

We believe a more conservative lending environment, where more limited capital market access enables lenders to better dictate terms and conditions, could spark liquidity challenges, accelerate downgrades, and ultimately lead to a spike in defaults.

And in a delicious bit of irony, in its more or less subtle manner, it blamed the Fed for the coming "spike in defaults":

After the financial crisis, quantitative easing-induced low interest rates enabled companies across the credit spectrum to borrow at attractive pricing and terms in the capital markets. And, until recently, investors were willing to accept the heightened risks associated with speculative-grade (rated 'BB+' and lower) debt in return for higher yields.

However, the residual hangover from years of lenient credit may become painful for lower-quality issuers, especially when lenders become more selective and discerning. As borrowing costs rise with market volatility and uncertainty, lower-quality borrowers, who opportunistically were able to tap the capital markets, will most likely feel a credit pinch in a more subdued and conservative borrowing environment.

The Fed's policies since the Financial Crisis have systematically destroyed the possibility to earn a visible real yield on low-risk corporate bonds or US Treasuries. So investors have embarked on a frantic search for yield, wherever they could find it, and they found it in junk bonds, and in chasing after junk bonds, they pushed those yields down too, and companies took advantage of it.

Since 2012, more than 75% of the companies issuing bonds were assigned on average a "B" category rating (B+, B, or B-), and thus deep into junk, with the "B-" rating carrying a 1-in-10 chance of default.

These companies were able to sell a record amount of junk-rated bonds - "above $300 billion" in three of the past four years.

As such, we believe corporate default rates could increase over the next few years, especially given the diminished growth prospects in China, the weak commodity and energy prices globally, the looming increases in domestic borrowing costs, and the sizable universe of lower-quality nonfinancial corporate debt outstanding.

At the same time, S&P-rated US corporations are facing a refinancing cliff: $4.1 trillion in bonds are maturing over the next five years. If companies cannot get new funds at affordable rates - now out of reach at the low end of the junk-bond spectrum - they might not be able to come up with the funds to redeem their bonds, and might therefore default.

But "on the bright side," the report explained, given the search for yield and the willful blindness to risk over the past four years, investors have allowed junk-rated companies to run over them and borrow at "generally favorable rates" and "under lucrative terms," which include "much greater leniency regarding covenants."

Those were the years when "covenant-lite" protections were all the rage. Fed-blinded investors gobbled them up. Once the credit cycle ends, which it now has, the lack of investor protections triggers larger losses in a default.

And also "on the bright side," companies have been able to push out the moment of truth:

In fact, the median maturity of U.S. corporate debt we rate increased to 5.5 years as of February 2016 from 4.5 years as of August 2015 because during the past six months many borrowers have paid down their near-term debt maturities or refinanced them with new debt with longer maturities.

But the moment of truth can't be pushed out forever, and "the decline in average rating quality could become problematic over time." S&P Capital IQ:

With global economic growth facing headwinds and companies experiencing diminishing returns from further cost-cutting initiatives, we believe profit margins will come under more intense pressure, with lower-rated issuers in particular having more trouble refinancing or finding new financing. This is especially true if all-in borrowing costs continue to rise at the rates they have as of late.

And so, the report concludes:

A recalibrated, smaller, and more conservative lending environment, where restricted capital market access will enable lenders to better dictate terms and conditions, could prompt liquidity challenges, accelerate downgrades, and ultimately lead to a spike in defaults.

And those yield-chasing, Fed-blinded investors - including bond mutual funds and pension funds - that made all this possible and that will eat that "spike in defaults?" Well, apparently, to heck with them.

As the artful QE bonanza is bumping into real-world limits, investment banking revenues, a key income source for "systemically important" banks, are having one heck of a terrible first quarter. Read… The Big Unwind Hits Investment Banking.