Fanning the Flames of Debt

Before the arrival of cheap, gas-fed monsters with instant ignition, those who were intent on quickly firing up their barbecues would turbocharge the process manually. Usually, this involved shoving wads of paper and twigs under and around the charcoal briquettes and then pouring copious amounts of lighter fluid on top, before setting several spots ablaze with one or more matches.

Occasionally, though, this was not good enough. Instead of waiting for nature to take its course, impatient types would fan the flames with their hands and mouths and shoot a continuous stream of flammable fluid at the glowing embers. Often, this would set off a mini-fireball that singed eyebrows and arm hairs. On occasion, the backdraft would be powerful enough to send the would-be barbecue-master to the hospital emergency room for treatment.

In some respects, the flow of cheap financing pouring into the coffers of companies already overheated with debt, as the following report from ratings agency Fitch seems to suggest, is creating an effect similar to squirting streams of combustible liquid on a nascent fire. Odds are that at some point, the smouldering pyre is going to burst into flames and the ensuing fireball is going to engulf everything around it--including those who've been doing the pouring.

Funding conditions for high yield U.S. corporate borrowers remained robust in the first quarter despite concerns that investor sentiment would shift following February's equity market sell-off and continued weakness in the housing market, according to Fitch Ratings. In fact, the share of newly issued speculative grade bonds rated 'CCC' or lower was again relatively high, accounting for 18.4% of the $40.8 billion in high yield bonds brought to market. Fitch believes that the yet undisturbed ability of deep speculative grade borrowers to access the debt markets is a major factor behind the very low default rate. Fitch has calculated that of the $124 billion in 'CCC' to 'C' rated issues currently outstanding (representing 16.5% of high market volume), more than 40% of the bonds have come to market in just the past two years and approximately 60% have been issued over the past three years.

The 16.5% concentration of 'CCC' to 'C' issues is not only large relative to similar historical periods of low defaults and robust economic growth but could potentially grow larger if credit quality begins to broadly deteriorate in an environment of softer economic growth and continued emphasis on highly leveraged transactions.

'Essentially what we have is a self sustaining pattern -- the ability of highly levered companies to tap the debt markets continues to depress default rates and very low default rates continue to support the issuance of low quality loans and bonds,' said Mariarosa Verde, Managing Director of Credit Market Research. 'The problem however is that defaults are falling while risk is growing as the share of low rated bonds and loans expands.'

Fitch calculates that the trailing twelve-month high yield default rate, already below 1% as of year end, contracted further in the first quarter, falling to just 0.4%, down from 0.8% for full year 2006 and far lower than the long-term average annual default rate of 5%. The default rate has reached new lows despite the large concentration of bonds rated 'CCC' or lower.

For perspective, in the mid 1990's, when strong economic growth and favorable funding conditions also contributed to below average default rates, the share of the high yield market rated 'CCC' or lower was substantially lower, averaging roughly 5% of outstanding issues. However, in the latter half of the 1990's, rising debt and slower profit growth pushed the share of high yield bonds rated 'CCC' or lower dramatically up, from 5% at the beginning of 1997 to 13% at the end of 2000, setting the stage for the record defaults of 2001 and 2002.

While current conditions support low default rates, it is nonetheless important to note that the number of issues at greatest risk for default once credit and economic conditions sour will likely be substantial -- perhaps higher than any other time in the past twenty years since the pool of these low rated bonds is already large and is likely to grow larger going forward as economic growth eases.

At that point, a lot of people are going to get burned.