Absent energy, junk defaults look unlikely

At the start of this year the rating agency Standard & Poor’s downgraded 19 high-yield oil and gas companies in the largest set of ratings downgrades for a single sector since 2009, saying the collapse in the oil price would hit company credits.
And the downgrades continue in the sector: in April, Moody’s, another ratings agency, put a further five oil and gas sector clients into its speculative grade population, which now comprises 189 issuers rated B3 Neg and lower, reaching levels not seen since November 2010, when the number in the group hit 191. The Moody’s industry heat map shows oil and gas remains the largest industry sector on that list, with the most names added on both a monthly and a yearly basis.

But outside the oil and gas sector, signs of distress in the high-yield markets in the US are few and far between. Christina Padgett, senior vice president at Moody’s, says: “We really don’t think there’s going to be much of a distressed market this year. Oil and gas is the one pocket of distress, but if you look at the liquidity index, absent oil and gas, it is probably as good as it has ever been and will remain that way for the next year, year and a half. Broadly speaking in the US we see the current environment as pretty stable – the default rate for Q1 was 1.9 percent and it is expected to go up by about 100 basis points a year from now, which is still low.”

In the States, six high-yield companies have defaulted so far this year, the most high profile being the bankruptcy filing by Caesars Entertainment, the gaming company, in January, and that of RadioShack, the electronics retailer, in February. Altegrity, a security and data recovery firm, also filed for Chapter 11 protection in February.

Padgett says: “The second sector after oil and gas in terms of ratings is the services sector, and that is such a broad sector that what is really true is that it is only idiosyncratic issues there, and very little that’s broadly making those companies vulnerable right now. In fact, the services sector shows up so much because it’s the sector that’s comprised of the most LBOs, so it is more aggressive management of balance sheets putting those companies at risk rather than anything in the economy.”

The size of the energy sector in the States has led to a divergence in the default rates between European and American high-yield, with only 2.4 percent of outstanding bonds in European high-yield related to issues in the oil and gas sector, compared to 16 percent in the US, according to Fitch Ratings. That agency said in a report in February that: “The lower oil price may have a net positive impact on European high-yield as lower input costs translate into better profitability and consumer-related issuers benefit from improved incomes. Differences in monetary policy further support divergence between the US and Europe.”

The European Central Bank began a programme of quantitative easing – injecting liquidity by buying government bonds – in March this year, six years after the US embarked on the same strategy. 

Paul Watters, head of corporate research at Standard & Poor’s, says the outlook for the distressed market is similarly weak in Europe, where there are limited signs of defaults in the high-yield bond space: “The number of defaults has been falling extremely sharply, particularly in the last year, supported by very low interest rates, favourable financing conditions and a gradually improving outlook for the European economy which all feed into supporting credit quality.”

He adds: “The companies that we are looking at – typically the upper mid-market or larger-cap corporates – have probably never had it quite so good in terms of access to liquidity and the terms and conditions they can get to refinance existing debt. Overall, it is difficult to see a material increase in corporate defaults occurring over the next couple of years barring some unexpected shock.”

That is a view shared by Richard Etheridge, associate managing director in Moody’s leveraged finance team in London. Moody’s expects default rates in Europe to stay low in 2015, and likely to drop to 2.4 percent by the end of 2015 compared to 2.7 percent a year ago. Etheridge says: “Default rates in Europe are currently below the long term average, helped by ultra-low interest and adequate levels of liquidity. This buoyant high-yield market has enabled higher-rated issuers to refinance at low interest rates, extend their debt maturity profiles and increase liquidity, while lower-rated issuers still depend on the market’s health at a specific time to gain access. 

“Another factor likely to keep defaults low is the extension of the debt maturity wall to 2018,” he says. “We have found that 65 percent of European debt due to mature next year is concentrated to Ba-rated companies, and those rated Caa1 and lower are likely to find refinancing more difficult or more expensive.”

He predicts the default rate to be highest in the aerospace and defence sector in Europe in the next 12 months, but points out that recent defaults like New World Resources, Phones4U and Norske Skog, a Norwegian paper company, were driven by company-specific issues rather than any notable sector trends.

Watters sees some concentration of weaker credits in consumer products, media, entertainment and leisure and metals and mining sectors in Europe. But he says: “Actually if you step back and think about where we expect much of the improvement in growth to come from, the more regional and local sectors should benefit. Domestic demand should pick up as low rates, low energy and commodity prices make consumers feel better off.”

The outlook for high-yield bonds in 2015 tends to suggest few high-profile defaults, with further positive drivers including an uptick in M&A activity, improvements to the recovery story in Spain, which has high corporate debt levels, and the refinancing of legacy callable debt. These themes all continue to provide upside potential in 2015, according to Fitch. 

But there will always be some issuers facing credit challenges. Etheridge says: “We could see issuers that previously restructured to address debt levels, but have not recovered in terms of profitability, facing distress, and they are likely to find refinancing more challenging. But more of those companies are currently financed via the loan market rather than high-yield bonds.”

On the other side of the Atlantic, distressed debt players may yet be wise to prepare for an uptick in activity. Padgett says that in the US: “The only caveat is that given how strong the market has been over the last couple of years, we have a lot of functional highly leveraged companies with low rates. So should the economy turn and liquidity dry up for some reason, those companies are maybe more vulnerable than, from a portfolio perspective, we have seen historically.”

She adds: “There may be some distressed players positioning themselves today, because it can’t last. The next default cycle will not look like the last one – it won’t be so severe but it could be longer, because it is unlikely that the Federal Reserve will fund it like it did this time. So it may be a lower default cycle with more companies affected. When that will come, however, remains a mystery.”

Distressed specialist Oaktree Capital Management has been anticipating this turn in the market for a while and is raising a $10 billion fund, split between $3 billion of funds for immediate deployment and $7 billion kept in reserve as the continuing benign outlook means Oaktree is reluctant to put itself under pressure to invest and will not charge fees on uninvested capital. The vehicle is expected to close in May. 

Oaktree’s new vehicle is not restricted by sector but a rash of other managers are raising energy-specific funds including GSO Capital Partners, Goldman Sachs Asset Management, Avenue Capital and Carlyle. 

A key development is the divergence in the high-yield space between America and Europe. Watters concludes: “What is clear is that the US is probably two years ahead of Europe, with the business and credit cycles diverging quite strongly. The financial policies that US corporates have adopted have been more aggressive than we have seen in Europe. There has been an enormous increase in US high-yield issuance, most of it in the single B space. The risk, at some point, is whether many of these companies will be able to service their debt and refinance in a different market environment. There could be quite a different story panning out in the US.”

With the troubled oil and gas sector currently underpinning global high-yield distress, that divergence is likely to continue for some time.