As the market stands witness to current low default rates, thin credit spreads, and downward flexes in the loan market, analysts from Standard & Poor's are worried that these current positive market trend indicators will paint the wrong picture for market followers.

In a research report published by S&P last week entitled, Market Indicators Offer Glimpse of Next Round Of Defaults, credit analysts reviewed the signs of weak credit quality, stating that lenders should focus more on negative outlooks and low recovery ratings. "It is becoming increasingly difficult to reconcile these positive indicators with credit realities at a time when capital is pouring into a record-high origination of speculative grade, fixed-income instruments," read the report.

"There seems to be a disconnection in terms of where we are in the cycle," said Diane Vazza, managing director and head of Global Fixed Income Research at S&P and author of the report. "One of the reasons we're so concerned with the lower grade issuance is that over the period of 1981 to 2004, close to 30% of triple-C's that were issued defaulted in their first year," she said. In addition, 12% of B-' rated bonds defaulted in the same time period, which although may be an improvement, is still a higher percentage than most bond holder's comfort level, she said.

Although thinner credit spreads may seem like an advantage to borrowers, they can also be viewed as an indication of higher credit risk, warned the report. The speculative grade market has seen a 12-month contraction in credit spreads from 445 basis points to 325 basis points and at the same time speculative-grade default rates tumbled in the U.S. to 2.29% in 2004 from 5.52%, said Vazza. "What we saw during that period of time was investors chasing yield, and as they did, the bullish sentiment in the yield market aged," she said. Bullish sentiment' meaning that although the rather extraordinary total returns in 2003 diminished somewhat in 2004, they nevertheless remained strong, Vazza explained.

During the last 12 months investors' risk tolerance also increased, noted Vazza, as in order to get more yield pickup, investors went further down the credit spectrum. "That's where we are now," said Vazza. "We have seen that hunger for yield manifest itself into the later stages of the high yield bull market to an increasing proportion of companies that are now on the lowest credit rung of our rating scale," she said. Therefore, B-' and lower rated bonds have been able to access the market, explained Vazza, noting that their proportion of new issuance in 2004 bumped up to 43% from 31% in 2003.

Moreover, Vazza said an increase in default rates was expected towards the end of 2005 and heading into 2006. "We are forecasting that U.S. speculative-grade default rates are going to decline slightly from where they are now, in early 2005, and then kick up in the latter part of 2005," said Vazza. "Our real concern for a more material increase is as we head into 2006 and beyond, although we are going to start to see that rise in the latter part of 2005," she added.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.