Follow the Corporate Default Trend?
By Dr. Scott B. MacDonald
New York (KWR) April 19, 2016 - Although the U.S. economy continues to muddle along, there are some worrying trends, one of which is the rise in defaults from non-investment grade rated companies. Thus far in 2016, companies around the world, with the largest number in the U.S., have defaulted on $50 billion in debt according to Standard & Poor's (S&P). While one should not feel compelled to leap off the proverbial cliff of worry, the trend is not in the right direction and appears set to grow worse.
On April 13th, Peabody Energy (BTU) filed for Chapter 11 bankruptcy. The company is the world's largest private-sector coal producer and serves metallurgical and thermal coal customers in 25 countries on six continents. It also had a consolidated debt of more than $6.3 billion, which was increasingly beyond its means in terms of repayment.
The bankruptcy was an end to a long, drawn-out downward spiral for Peabody and the U.S. coal industry. In its announcement, the company stated: "The factors affecting the global coal industry in recent years have been unprecedented. Industry pressures in recent years include a dramatic drop in the price of metallurgical coal, weakness in the Chinese economy, overproduction of domestic shale gas and ongoing regulatory challenges."
The above statement reflects some of the litany of problems facing many high yield American companies, many of them in the energy and mining sector. According to Moody's Investor Services in 2015, metals and mining had a default rate of 6.5 percent, followed by the oil and gas sector at 6.3 percent. In sum, there were 109 defaults in 2015, almost double the 55 counted by Moody's in 2014 respectively at $97.9 billion compared to $71.4 billion.
There is more pain to come. According to Standard & Poor's, the number of defaults on a global basis was up by 5 last week, including the first European company in 2016, the largest producer of newspaper and magazine paper, Norway-based Norske Skog. This takes the total of defaulting companies to 46 since the beginning of the year.
S&P forecasts roughly 4 percent of non-investment grade U.S. companies will default by year-end, which is more than double the number in 2014. The rating agency's Diane Vazza stated: "Stress in the form of persistently low oil prices, the tightening of monetary policy by the Federal Reserve for the first time in nine years and slowing global growth will likely produce more defaults in the next 12 months."
The current environment has been a little more positive than the first two months of 2016. According to Bank of America data, yields on high yield bonds have fallen from more than 10% in February to under 8% and the average bond in Merrill Lynch's index now trades at 91.5 cents on the dollar, up from a low of 83 cents in February. While this has been a great development for investors savvy enough to buy at the lows, it also signals that this market maintains considerable potential for volatility, especially considering the menu for risk events, many of them of the quirky geopolitical variety such as the Brexit vote (June 23rd) and the U.S. presidential elections.
Another factor worth watching on the default front for companies is the tightening of bank credit. Banks enjoyed the ride up that came with the U.S. energy revolution; the ride down meant rising (but containable non-performing loans in energy and mining names) and a substantial reduction in credit facilities. This has been evident in announcements by Citigroup, JPM Chase, Bank of America and Wells Fargo.
While the bank's tighten credit, the struggling energy sector companies have morphed into two groups - those that still have enough creditworthiness to head into the more expensive public debt and equity markets and those who cannot and are left hoping oil and gas prices rise again. Considering the lack of progress at the Doha OPEC meeting this past weekend that is not a good bet.
Those companies able to access markets have been active. According to Dealogic, exploration and development companies (one of the sectors most under pressure on the default front) have raised $7.8 billion through new equity share offerings, with Noble Energy and Whiting Petroleum leading the way. At the same time, public debt markets have seen high yield energy companies come to market for $9.1 billion in Q1. More deals came in April.
The big question is when does the spigot get turned off? With mounting risks, the closer to June's UK Brexit vote comes, the tighter credit is likely to be - even in public debt and equity markets. Problems with the Chinese economy, major terrorist attacks or a Middle East crisis also remain on the radar. The chance for a repeat of extreme downward volatility of the likes of January and February cannot be ruled out.
S&P maintains a count of "weakest links", which is companies that have a greater potential for default. At the end of March, the number of weakest links stood at 242 companies, the highest since 2009. Among the names of companies that are highly indebted and struggling are Intelsat and Neiman Marcus.
Considering that U.S. industrial production was down again in March, 2016 (by -0.6%, following January's and February's -0.5% and -0.6% respectively), the bad news on corporate defaults is not good news for the U.S. economy. Add to this the expectation of a poor earnings season, exports hurt by a strong dollar and less than stellar consumer demand, Q1 2016 looks weak, probably trending a real GDP growth of around 1.0%, possibly lower.
Prospects for Q2 are not looking much better, though there is hope that the worst on the economic front may be behind us if oil prices finally stabilize above $40 a barrel, wages gain more traction and the Federal Reserve continues to advance cautiously on the rate increase front. And then there is the U.S. housing market which remains a point of concern, especially with the developing housing shortage which is the most acute for lower prices and affordable housing. This leaves the Federal Reserve in a very cautious mode and 2016's real GDP may struggle to reach 2.0 percent by year-end. This does not provide a great business environment.
The corporate default rate trend is likely to increase through the course of 2016. The trends are already in place for this happening. The major unknown is as to what level the default rate will eventually be. While there appears to be a consensus that there is a spike, the question is to what levels. At this junction it is difficult to see a spike in default rates heading over 4%-6%.
However, with the range of uncertainty hovering over the global and U.S. economies, corporate defaults can be added to the menu of items that could inject more volatility in markets. Risk remains a factor in markets and non-investment grade rated companies are likely to be strongly tested in the months ahead.
While the information and opinions contained within have been compiled from sources believed to be reliable, KWR does not represent that it is accurate or complete and it should be relied on as such. Accordingly, nothing in this article shall be construed as offering a guarantee of the accuracy or completeness of the information contained herein, or as an offer or solicitation with respect to the purchase or sale of any security. All opinions and estimates are subject to change without notice. KWR staff, consultants and contributors to the KWR International Advisor may at any time have a long or short position in any security or option mentioned.
KWR International Advisor
Editor: Dr. Scott B. MacDonald, Sr. Consultant
Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant
Publisher: Keith W. Rabin, President
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