Published: July 01, 2009
Diane Vazza, a Managing Director at Standard & Poor’s Ratings Services, discusses the findings of the rating agency’s latest Annual Global Corporate Default Study and Rating Transitions.The year to-date count of defaults by S&P-rated corporates now stands at 68 globally – well more than triple the 19 defaults that occurred during the same period in 2008. Meanwhile, by region, the US has maintained its lead, with 54 defaulted issuers so far this year.
Furthermore – as Standard & Poor’s latest Global Corporate Default Update, published 6th April 2009, also reports – 35% of defaults this year are outside of the US. This contrasts with 5% of defaults this time in 2008 – illustrating just how global the current economic and credit pressures have become.
Default rates in the spectulative- grade rating categories are well below the record levels seen in prior cycles.
In addition, Standard & Poor’s has also recently published its Annual Global Corporate Default Study and Rating Transitions for 2008. This study charts the dramatic deterioration in corporate credit quality that occurred in 2008, as well as detailing the year’s default occurrences which picked up sharply in each progressive quarter of the year, yielding a final annual tally of 125 defaults globally – a figure which contrasts starkly with the ultra-lows seen a year earlier.
Examining these default rates is valuable because all of Standard & Poor’s default studies have found a clear correlation between ratings and observed default frequencies: the higher the rating, the lower the observed frequency of default, and vice versa. In fact even in 2008, amid high turbulence, the ability of corporate ratings to serve as an effective measure of relative risk has remained intact.
Many default studies, including this one, also look at transition rates, which gauge the degree to which ratings change – either up or down – over a particular time.
Indeed, transition studies have repeatedly confirmed that higher ratings tend to be more stable and that speculative-grade debt generally experiences more rating volatility.
Analysis of transition rates over the four quarters ending December 2008 suggests that ratings behaviour continues to exhibit consistency with long-term trends, showing a clear negative correspondence between credit rating and default probability. Indeed, Table 1 demonstrates that investment-grade-rated issuers – globally – tend to exhibit greater credit stability (as measured by the frequency of rating transition) than their speculative-grade counterparts.
For instance, 87.59% of issuers rated ‘A’ at the beginning as of January 1, 2008, were still rated ‘A’ by December 31, 2008, whereas the comparable share for an issuer rated ‘B’ was only 73.16%. The same relationship holds even when the transition rates are analysed separately for the US, Europe, or the emerging markets.
Notably, some unusually large transitions from ‘AAA’ to ‘B’ and ‘CCC’ observed in the table are attributable to pronounced deterioration among some monoline insurers, notably FGIC Corp, FGIC UK Ltd., and CIFG Guaranty.
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Nevertheless, despite this general consistency, exceptional volatility in the financial markets claimed a higher volume of highly rated financial defaults than normal in 2008. In fact, expressed as a percentage of the total issuer count, the overall default rate rose globally to 1.69% in 2008 from just 0.36% a year earlier, while the investment-grade default rate rose to 0.41% – its highest annual rate since 2002.
Certainly, last year proved memorable in a multitude of ways that will continue to be described and analysed in history books in the years to come. In the US, for example, a number of records were set during the previous 12 months. This began on January 5, with the unemployment rate hitting 5% – the highest level in more than two years – and the tone was maintained for the rest of the year, with new unemployment records set progressively. Furthermore, on June 9, the average price for gasoline reached $4/gallon for the first time, while on November 20, consumer prices in October fell their furthest in a one-month period since World War II.
Consequently, this extraordinary financial turbulence drove 2008 default rates to record highs. Indeed, the 60 defaults in the final quarter of 2008 constituted the highest number of defaults since the first quarter of 2002. Conversely, the volume of debt affected by the defaults rose to US$214bn in the fourth quarter, which – on a quarterly level – is the highest amount on record. Meanwhile, although the trend in the quarterly default rate visibly picked up in the final half of 2008, it still remains below the peak recorded in the 2002 upturn.
By region, the US led the charge in 2008 with a speculative-grade default rate of 4.02% compared with 2.54% in Europe and 1.96% in the emerging markets.
Furthermore, record highs were even seen among some investment-grade rating categories, notably ‘AA’ and ‘A’, where default rates rose to a record high of 0.38%.
Importantly, however, there were no defaults in the ‘AAA’ rating category, affirming the historically low default record of the highest rated corporates.
In addition, a comparison with the long term reveals that 2008 default rates in the ‘AA’, ‘A’, and ‘BBB’ rating categories exceeded their long-term weighted averages but remained lower than this threshold in the ‘BBB’ and ‘BB’ rating categories. For example, the 3.82% default rate recorded among entities rated ‘B’ (includes ‘B+’, ‘B’, and ‘B-’ ) in the most recent four quarters was below the 4.51% long-term average as well as the 8.10% recorded during the most recent peak in 2002.
While at the same time, default rates in the speculative-grade rating categories are well below the record levels seen in prior cycles.
The study also shows that the time to default from original rating shows some variation by sector. Of the 1,668 defaults recorded globally over the long term, six sectors display an average time to default that is lower than the overall average of 5.7 years. These are energy and natural resources, financial institutions, high technology, leisure time/media, real estate, and telecommunications. [[[PAGE]]]
By industry, the highest default rates in 2008 were in the leisure time/media sector, followed by the forest products and homebuilding sector. The variation by industry stems partly from sample size differences as well as differentiation in the rating mix across sectors.
Nevertheless, financial entities more than doubled their share of total defaults in 2008 in comparison with the long-term average, accounting for just over 20% of total defaults compared with 10.6% in the long-term statistics.
As well as discussing default rates, the study also records that of the 5,966 corporate issuers rated globally by Standard & Poor’s Ratings Services at the beginning of 2008, 15.82% were downgraded by the end of the year – the highest downgrade rate since 2002. Moreover, the downgrade to upgrade ratio moved up to a five-year high of 2.05, while the average number of notches recorded among downgrades rose in 2008 to 1.63 – a pace also unmatched since 2002.
Indeed, at the end of 2008, credit trends dipped for the worse in no uncertain terms, with downgrades exceeding upgrades globally by the biggest margin since 2003.
In addition, amid the elevated turbulence, the number of entities experiencing large, multi-notch downgrades escalated to a high of 21 issuers in 2008 – its highest level since 2001. These big movers are defined as entities that experienced rating downgrades (or upgrades) of seven notches or greater. Of note, financials accounted for more than half of the big movers, the highest share recorded since 1992.
The consequence of these conditions was that the average Gini ratio – which is a measure of the relative ability of ratings to differentiate risk over the 1981-2008 period – dropped to 82% as a result of the sharp deterioration of the one-year Gini ratio in 2008 to 65%.
This is not surprising, given the extraordinary volatility in the financial environment during the course of 2008. A measure of change in credit quality – which combines the average change in the frequency of downgrades or upgrades and magnitude of such rating transitions, weighted by the total number of issuers outstanding in each sector – is displayed in Chart 1. Note the especially sharp trajectory of decline within the global financial sector, which saw an unprecedented reversal after starting from a net position of strength at the end of 2007.
Certainly, this rise in corporate casualties comes on the heels of many consecutive years of heady growth. Indeed, the noteworthy deterioration of the global corporate rating distribution (and the coincidental drop in the median rating) in the last five years was a visible symptom of the ‘boom’ years, characterised by easy lending conditions, rock-bottom spreads, and a bulging rise in low-grade originations.
We at Standard & Poor’s expect that the current wave of defaults will restore a greater sense of equilibrium to the spectrum of ratings, resulting in a distribution that tips closer towards investment grade, as was the case in 2003. This dynamic results when the volume of defaults more than compensates for the new entrants into the speculative-grade universe, either from downgrades or from originations.
Nevertheless, as Standard & Poor’s Global Credit Comment published on 26 March 2009 reports, the reality remains concerning. For instance, a further 297 global corporate entities are currently teetering on the brink of default. In fact, the number of global weakest links has increased for the 13th consecutive month to a record high as credit quality has continued to erode, leading to lower ratings and more entities with negative outlooks or with ratings on CreditWatch negative. These ‘weakest links’ (almost three times the number from a year ago) have combined rated debt worth $520bn.
The marked increase in weakest links will likely lead to further credit degradation, with entities at the lower end of the ratings spectrum tending to be more volatile. Moreover, historical analysis shows that once companies qualify as weakest links, the likelihood that they will default escalates sharply in comparison with the rest of the speculative-grade segment. This rise in weakest links is indicative of the gloomy default outlook for the remainder of the year and through 2010.
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