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High Yield Bond Defaults
- The High Yield Bond (HYB) default rate has experienced two peaks - in 1991 and 2002 when it reached 10.3% and 12.8%, respectively. However, due to the explosive growth of the overall HYB market from 1991 to 2002, the volume of defaulted paper increased about 5.1x in that period from $19 billion in 1991 to $97 billion in 2002.
- Over the past 15 years, the HYB default rate has averaged approximately 5% a year through all the economic cycles. Based on the current $1 trillion HYB marketplace, this would imply an average "normalized" annual HYB default volume of approximately $50 billion, which is roughly the amount we saw in 2002 if you exclude the $50 billion or so of one-time-only defaulted "fraud" paper issued by WorldCom, Global Crossing, et al.
- Through the first eight months of 2004, however, the HYB default rate is less than 1%, with only $7 billion of defaulted paper. In fact, if the current pace of defaults continues through the end of the year, 2004 will have the lowest HYB default rate in the past 15 years.
- The question many people are asking is whether 2004’s low HYB default rate is a new trend?
What’s our view?
Look for the HYB default rate to increase substantially in 2005. Why do we think so? Four reasons:
- Rising interest rates. We’ve recently experienced a significant HYB default rate notwithstanding the lowest interest rate environment in the last 50 years. As rates rise - and the Fed has just raised them for the third time this year - many companies that are on the cash flow bubble will inevitably be tipped over the edge. This is particularly true, as we point out in the next "Thought", in those industries where most companies have little or no pricing power, such as automotive suppliers and furniture manufacturers.
- An increasing number of questionable credits among 2003 HYB issuances. The amount of new issue HYB paper in 2003 that was rated B- or below, or not rated at all, jumped to almost 20% of new issuances in a market that saw a near-record amount of underwriting. This trend has continued in 2004. Many of these companies will not make it, particularly starting in the second year after issuance, which is the time period when most defaults occur.
- Rising energy prices. Oil just hit $50 a barrel. Industries that are heavily affected by fuel costs - such as airlines and many basic manufacturing businesses - are in for a tough time as energy costs continue to rise.
- The law of averages. Other than historically low interest rates, there have been no fundamental economic changes in the last several years that would signal a permanent reduction in the default rate. Since interest rates are now returning to more normal levels, and given the presence of other negative factors such as the uncertain economic recovery, the deteriorating situation in Iraq, ongoing terrorism fears, and record budget deficits, we fully expect the default rate to return to its historical average.
Middle Market Squeeze
- Why is it that so many middle market companies feel like they’re being squeezed to death at a time when the economy supposedly is improving? One reason is because many of these companies are in largely fragmented industries where individual companies have little or no pricing power due to the multitude of competitors. As their raw materials costs increase, they are simply unable to pass along these higher costs to their customers in the form of higher prices. Or they can’t raise their selling prices due to competitive pressures.
- As an example, take a look at Citation Corp. Citation is an automotive supply company that recently filed for bankruptcy protection because it was unable to pass along the huge price increases in steel scrap (which went from $150 to $480 a ton over the last year) to its customers, which include GM, DaimlerChrysler and bus-maker Blue Bird. The automotive supply industry is widely dispersed without any dominant players and competition is based mostly on price. Many foreign competitors enjoy superior cost structures due to their low labor costs and are thus better able to survive the downward pricing pressure applied by their customers.
- Want another example? Try Bush Industries, a furniture manufacturer that also filed for bankruptcy protection due to an inability to raise their selling prices as a result of intense price competition. The North American furniture industry is also widely dispersed with 15-20 strong competitors who mostly compete on price. While the larger companies in the industry are able to lower their costs by achieving economies of scale, the middle-level ones are not able to do so and are faced with increasingly smaller profit margins.
What’s our view?
There are hundreds if not thousands of companies like Citation and Bush that simply don’t have the size, pricing power and wherewithal to pass along cost increases to their customers or to stave off price competition from competitors with superior cost structures. These middle market companies represent the true backbone of the U.S. economy. As they continue to be squeezed to the breaking point, look for a huge ripple effect - loss of jobs, bankruptcies, reduction in municipal tax receipts, etc. For a critical gauge of the economy, look to the middle market.
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Miller Mathis is pleased to announce the first member of its new Advisory Board: Prof. Edward Altman
Professor Altman is widely recognized as the country’s leading analyst and statistician on high yield bonds and the distressed debt marketplaces. Professor Altman has published or edited almost two dozen books and over 100 articles in scholarly finance, accounting and economic journals and has served as a consultant to numerous government agencies, companies and executives around the world. He is the author of best-selling books such as "Bankruptcy, Credit Risk and High Yield Junk Bonds" (2001) and "Managing Credit Risk" (1998). He is currently the Max L. Heine Professor of Finance at the Stern School of Business of New York University. He also directs the Research Program in Fixed Income and Credit Markets at the NYU Salomon Center. Professor Altman is the current editor of the Handbook of Corporate Finance and the Handbook of Financial Markets and Institutions and is the Chairman of the Academic Council of the Turnaround Management Association. He was inducted into the Fixed Income Analysts Society Hall of Fame in 2001 and elected President of the Financial Management Association in 2003. Professor Altman received his MBA and Ph.D. in Finance from the University of California, Los Angeles.
For more information on NYU's "Frontiers In Finance" executive seminars please go to www.stern.nyu.edu/salomon.
Miller Mathis is a boutique investment bank that provides its clients with sophisticated insights and creative solutions for complex business issues.
The views expressed herein are those of Miller Mathis only. Nothing contained herein should be considered as investment advice. Miller Mathis disclaims any and all responsibility.
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