“Spike in Defaults”: Standard & Poor’s Gets Gloomy, Blames Fed

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“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



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  31 comments for ““Spike in Defaults”: Standard & Poor’s Gets Gloomy, Blames Fed

  1. NotSoSure
    March 27, 2016 at 9:50 pm

    Oh no, I suspect we will truly reach Dow 30K this time.

  2. CrazyCooter
    March 27, 2016 at 10:07 pm

    Not to be redundant, or perhaps, unoriginal, but I just posted this youtube clip over at ZH on a wholly unrelated, but related thread:

    https://www.youtube.com/watch?v=bPXVGQnJm0w

    This isn’t the first time – I feel it very accurately describes markets these days. War style intervention at every level, casualties at every level, costs at every level – all in an attempt to hold on to the thing that can’t be held on to.

    I wasn’t clear in my posting on ZH so I did an “EDIT” and amended my meaning. Sometimes I have too many things in my head (e.g. C2H5OH, etc) and I am occasionally both quite verbose and not quite on point.

    The operative part of this, and I think it is spot on in so many ways, is the final bit – “Some day this wars gonna end.”

    By choice? No, because it can’t go on. And to be clear, I mean, one day, the CBs just won’t be able to pinch off another turd and sell it as gospel to the congregation. Rates will finally go up – or the currency will cease to exist (i.e. have value).

    Neither is really very good.

    Start thinking about what that looks like for you and yours.

    Regards,

    Cooter

    • d'Cynic
      March 28, 2016 at 12:21 am

      I compare the current state to a falling rock. You can hear it, but you are not sure where and when it will hit. It leaves you in a state of stupor. Either way, mankind will not die out because of global warming, it will do so because of the combined genes of stupidity, laziness, addiction to hopium, and deference to bogus leaders.

      • Markar
        March 28, 2016 at 10:27 am

        Wiley Coyote comes to mind.

  3. Michael Gorback
    March 28, 2016 at 12:15 am

    Hangover is a great analogy, as in blaming the bartender for your hangover.

  4. Agnes
    March 28, 2016 at 2:59 am

    Teachers and State employees do not really realize that their pensions are at risk(unless they live in Illinois or a few other places). One of the simple reasons for the increase in price for financial instruments was the increase in demand for them. Now that the boomers are NOT seeking alpha but instead seeking security, the demand has gone down. But the “5 year plans” of the fiduciary companies running the retirement funds hide their lack of solvency. Thanks again Wolf for a great piece.

    • West
      March 28, 2016 at 9:17 am

      What I’ve witnessed among my boomer contacts is the attitude that the coming pension defaults don’t matter to them because it’s not their pension fund and it doesn’t affect them directly. Oh, but it does – They are all interconnected.

      • Petunia
        March 28, 2016 at 11:37 am

        The boomers are aware that the problem is just under the surface. Jeb lost Florida because he stuffed the state pension fund with Lehman junk after he left the governorship. People remembered it and didn’t want to set themselves up for an even bigger ripoff sending him to DC. I understand that Florida is now in the process of changing the state pension fund into a pension and 401K to help stem the losses they know are coming.

    • March 28, 2016 at 1:49 pm

      The Illinois Supreme Court ruling that pension obligations are sacrosanct and cannot therefore be modified (reduced) sounds good on the surface, but will not matter or save the day.

      CPS and the State of Illinois are fast running out of money and scams to paper over this reality. Teachers are going to take it in the shorts in Chicago, Cook County and every other nook and cranny in Illinois. The piper will be paid. There is no Free Lunch.

  5. TheDona
    March 28, 2016 at 8:45 am

    Here is how China is going to prop up their stock market…..putting their massive pension plan money in it. Only in “A” shares at first. How comical is this?

    http://www.chinadaily.com.cn/business/2016-03/28/content_24126473.htm

  6. Petunia
    March 28, 2016 at 9:06 am

    There’s a lot of debt out there connected to the big corporate house renters, the ones that bought all the foreclosed homes. I think most of that debt is going to go bad sooner rather than later.

    I rented from one of them in Florida and the rent was already at the top of my affordability threshold. When my lease was up they raised my rent 6%, but our income had dropped 15%, and we were now paying above 50% of our take home in rent. We could no longer stay and didn’t want to anyway. We never want to rent from a large corporate renter again.

    In addition, the house had many problems during the year we were there. I estimate that at least 50% of the rent went to repairs. They make cosmetic repairs to rent the houses but the houses have code violations that continue throughout the rentals.

    The company I initially rented from merged into another bigger rental company during the year. I was not surprised to see this, and thought it was a move to hide the expenses from the “investors”, through the accounting of M&A.

    If the investors are planning on a big payoff when these houses sell, I think they will be very disappointed. The houses are poorly repaired and badly managed. Besides, their model of raising rents every year is impossible to sustain in the current employment environment.

    • TheDona
      March 28, 2016 at 10:22 am

      Black Stone is the largest US landlord using their subsidiary arm, Invitation Homes, to manage them.
      Somehow BlackRock and Blackstone are intertwined or at least were birthed from some of the same hedge fund asshats. BlackRock lists a Rothschild as one of it’s board members. It’s all one big incestuous mess.

      • bud
        March 28, 2016 at 12:13 pm

        And look who was behind their financing….

        Drum roll…
        Deutsche Bank of course.

        And how did a German bank get the money to lend?

        Why the Federal Reserve free money window, of course.

        The Federal Reserve and the banks ( foreign and national) who own the stock of the FED have destroyed the American middle Class and the dream of home ownership, just to list TWO items. No so called enemy of American could have done that without our military march in. So, no guns, no bombs, no mussel ….but plenty of sheep and help from within.

        Now to add to the disgrace. Any bank that was involved in any fraud involving housing was no longer eligible to make home loans via FHA<VA< Fanny, etc. Our great leader used his executive pen to change the HUD rules, no need for Congress to get involved.

    • Nicko
      March 28, 2016 at 11:57 am

      Check out the recent movie ’99 Homes’, eye opener.

    • TheDona
      March 28, 2016 at 12:59 pm

      There will be some new tax codes passed and they will at the end make money on on the books. In real life like you and I consider making money…no. But with Accounting magic…yes.

    • March 28, 2016 at 2:00 pm

      Petunia, you are living proof that what doesn’t kill you makes you stronger (and more agile and smarter). Wolf Street commentors are very articulate and bring a lot to the table, but we particularly enjoy your unique perspective.

  7. OutLookingIn
    March 28, 2016 at 11:12 am

    Please Sir, I want some more.

    With six credit cards, four of which are in payment arrears and the remaining two at their credit limit, the corporate sector is waiting on pins and needles to hear the verdict on whether they are approved for a seventh credit card, so they can borrow to pay the arrears on the first four!

    Meanwhile back at the ranch, all those credit card balances (corporate & private), loans (cars & consumer), have been bundled up into “asset” backed securities, collateralized loan obligations and credit default swaps derivatives and sold to pension funds, hedge funds, municipalities, as triple ‘A’ investments!

    What could go wrong? Right?

    • polecat
      March 28, 2016 at 2:19 pm

      Bundles of sh!t to be spread to the muppets, fools, sheep, marks, chumps, serfs, plebes……….on, and on, and on !!!!

  8. Chicken
    March 28, 2016 at 1:01 pm

    Assuming corporate debt truly is unsustainable, the why are we at full employment? Are we to assume corporations are committing suicide at all levels?

    There’s something askew, would love to know the truth.

    • March 28, 2016 at 1:31 pm

      Good questions.

      Actually, corporations aren’t into suicide. It’s investors (stockholders, bondholders, banks, etc.) that are in for a drubbing when things turn sour. Chapter 11 leaves the corporation and its executives mostly intact, while strip-mining certain (but not all) investors. There can be big winners in a Chapter 11 filing, including the corporation, which will shed much of its debt.

      • polecat
        March 28, 2016 at 2:27 pm

        well Wolf, then perhaps the laws of incorporation need to be changed so that said corps. & executives get the same (or worse) drubbing that the investors would receive in a Chapter 11 bankruptcy……the public would be for it hands down!!

      • bud
        March 28, 2016 at 5:49 pm

        If it is good enough law for student debt, then it is good enough for corporate debt. It should not be discharged, if student debt can not be.

        How tight can the spring be wound?

    • March 28, 2016 at 2:05 pm

      The something ‘askew’ is that ‘we are at full employment’. We are anything but, as the real unemployment rate is about 23%.

  9. dave
    March 28, 2016 at 4:48 pm

    wolf the the problem I am curious about is say these corporations seek chapter 11. do the shareholders get wiped clean as well? or do the still hold ownership throughout?

    • March 28, 2016 at 5:07 pm

      It depends. Most of the time, the equity is transferred either in part or completely from current shareholders to creditors (who take it in exchange for giving up some debt).

      For example, in the last Delta Airlines bankruptcy, Delta’s outstanding shares were just cancelled, and no longer represented anything of value (though people kept trading it for a while on pink sheets). And it issued new shares … those that you can buy today. In that case, shareholders got wiped out completely. This is very typical for a chapter 11.

      In some bankruptcies, the original shareholders are heavily diluted but retain some ownership.

      Chapter 11 is essentially a transfer of ownership to creditors. They’ve got all the power in a Chapter 11 filing, and shareholders have essentially no power.

      • QEternity
        March 29, 2016 at 1:28 am

        The “dirty little secret” no one on Wall Street tells investors is you are FAR FAR better off owning senior debt (secured preferably) in a corp that will pay you 5% than stock that will give you a dividend of 5%.

  10. Chicken
    March 28, 2016 at 10:49 pm

    “It depends. Most of the time, the equity is transferred either in part or completely from current shareholders to creditors (who take it in exchange for giving up some debt). ”

    Thus, it’s wiser to be the creditor than the shareholder, no?

    • March 29, 2016 at 12:24 am

      Yes.

      That’s why all the PE firms that are now dabbling in oil and gas are going after second-lien or first-lien debt. Unsecured debt might not be much better off than equity in a bankruptcy.

      These kinds of bonds are practically impossible to buy for retail customers. Most brokers don’t sell junk bonds to their clients.

      Also, even if you can buy these bonds, you really need to know what you’re doing because in the end, there’s a legal battle that you need to win.

  11. QEternity
    March 29, 2016 at 1:32 am

    I don’t expect the FED to EVER stop bailing when TSHTF. Helicopter money, whatever it takes, they’ll try it. Untill it all collapses in a smoldering heap.

    Today, for the first time, I have actually begun to entertain buying some BitCoin.

    In the past I have diversified into gold, silver, and foreign farmland. I worked too damn hard to have these fools destroy everything with their monetary madness & Keynesian Krackpot Kaper.

  12. Berserker
    March 29, 2016 at 12:47 pm

    I’d like to posit a haphazard theory about the bigger macropolitical situation.

    Would it not be possible that there is simply a completely new world order on Wall Street, and most of the investment houses just haven’t really digested it.

    This new world order would be a total abolishment of bonds. Interest rates permanently kept at zero percent, and as a result a constant inflationary build up of valuations. It’s just numbers. The actual exchange value doesn’t get affected that much.

    It’s a new Ponzi scheme. Those in the cash origination business get better value because they’re the source of inflation. Same for those who already own fixed assets. The long term result would be abolishment of physical currency altogether, essentially like Weimar Republic.

    I don’t think this would necessarily cause widespread havoc because of the inherent balancing effects of all trade activities. As soon as you exchange value for value, it doesn’t matter what price tag it has. Except of course if you’re paying with value that is constantly depreciating. Like money. Or junk bonds.

    So the bond business would go belly up. But in a drawn out process, there would be simply a business model adjustment for those who engage in this type of trading. There is always something else that can be traded.

    Curious what you think.

Comments are closed.