Uncertainties surrounding European sovereign debt, scarce and expensive debt finance, and the prospect of more than €69bn of speculative-grade debt maturing over the next two years are key problems for corporate treasurers in 2012 and could drive the European corporate default rate above 6% over the coming quarters.
Our base-case European speculative-grade default forecast of 6.1% for the full year would equate to 41 companies in our rated universe defaulting by the end of the year, up from 4.8% at the end of 2011. However, in a downside scenario, the default rate may climb to 8.4% or even higher if the economic and financing environment deteriorates further due to a deeper or more protracted recession in Europe.
Standard & Poor’s’ (S&P’s) rated universe comprises 676 speculative-grade companies – that is, rated BB+ or below – domiciled in the EU27 countries plus Iceland, Norway, and Switzerland with either public credit ratings or private credit estimates. The base-case scenario represents a modest upward revision to S&P’s previous forecast of 5.5%-7.5% at the start of 2010. Yet, even at this rate, prospective defaults would remain well below the peaks reached in the third quarter of 2009, when the trailing 12-month default rate hit 14.7% in Europe.
Looking Back on a Tough Year for Corporates
The increase in the default rate to 4.8% in the fourth quarter 2011 follows a low of 3.7% at the end of the third quarter, which S&P believes marks another turning point in the default cycle. During the 12 months to the end of December 2011, 34 companies defaulted on €19.5bn of funded debt. Of these, the majority (30) were in S&P’s private credit estimate portfolio, accounting for €15.5bn of the total debt.
There were only two defaults in the first nine months of 2011 among the publicly rated speculative-grade portfolio – Czech gaming company SAZKA and French health-service provider Novacep Holding. This marked a fall in the trailing 12-month default rate based on public ratings to a new cyclical low of 0.9%. However, the two public defaults in the fourth quarter – of Italian directories business Seat Pagine Gialle and Greece-based Yioula Glassworks – resulted in the trailing 12-month default rate increasing to 1.7%.
From a value perspective, the trailing 12-month rate of defaults by volume of debt outstanding stood at 3.1% at the end of 2011, up from a low of 1.9% at the end of the second quarter of 2011, a little above the 2.9% level that S&P calculated for the end of the fourth quarter in 2010. This is based on S&P’s estimate of the outstanding amount of funded debt, including loans and bonds of €623bn for those EU30 public and private companies in their datasets, using the latest available accounts.
Within this total, S&P estimates that outstanding loans from private companies in their datasets have fallen to €245bn, compared with about €354bn in 2009. We believe this reduction reflects a combination of three factors – prepayments, where leveraged buyouts (LBOs) have been acquired by trade buyers, refinancing of loans in the speculative-grade bond market and restructurings involving loan write-offs and loans no longer held within collateralised loan obligation (CLO) portfolios.
Factors Fuelling the Rise
S&P believes that the renewed uncertainty regarding the solvency of certain eurozone sovereigns in the European Economic and Monetary Union (EEMU) since last summer marks a turning point for corporate defaults for at least three reasons:
1. Deteriorating economic environment
Obviously, business prospects in Europe have taken a turn for the worse, with at least a shallow recession now in prospect for the first half of 2012. S&P’s economists have scaled back their base-case economic forecasts for the eurozone, as well as the UK. They expect a shallow recession in the first half of 2012 in the eurozone, with countries enduring austerity measures dragging on the still positive growth that is anticipated in Germany and other northern European countries.
2. Tighter bank lending
Just as relevant for the default outlook given the high percentage of highly leveraged companies in S&P’s speculative-grade portfolio that still need to refinance over the next two to three years – is the fragile condition of the banking industry which has become more evident over the past few months. Specifically, this includes:
- An excessive dependence on European Central Bank (ECB) liquidity due to the freezing up of the interbank market.
- The limited ability of even top-tier banks to raise unsecured funding in the debt capital markets.
- The requirement that banks achieve core Tier 1 equity targets of 9% by the end of June 2012. This is prompting a rapid reduction of risk-weighted assets for many major European banks, including the sale of non-core businesses.
- Banks shifting business priorities back to their core market(s).
S&P believes one consequence of these developments is that it will be important for European banks to credibly demonstrate the quality and strength of their newly fortified balance sheets.
3. An end to the phoney war of forbearance
Somewhat related to the second factor, S&P sees signs that the phoney war of forbearance may be coming to an end. The policy of temporary relief by senior lenders for borrowers in distress is reaching its limits given the proximity to principal maturity dates in 2013-2014 and the pressure on banks to improve the quality of assets on their balance sheets.
For S&P, this implies that senior bank lenders are increasingly likely to adopt a more robust stance to disposing of noncore assets or taking appropriate remedial action to address loan exposures – where underperforming businesses with overleveraged balance sheets have approaching maturities. The recent announcements by the new Spanish government that it will require Spanish banks to increase provisions on impaired assets are a strong signal that a new sense of realism is seen as a necessary step towards restoring confidence in the banks.
If this new realism takes hold in other countries in Europe, it would in our view likely translate into a greater number of restructurings of vulnerable overleveraged LBOs, many of which have already experienced a light restructuring in recent years. At the end of December 2011, 34% of our private credit estimate portfolio was at b- and 14.4% at ccc+ or below. This is higher than 28% and 16.1%, respectively, at the end of 2010. Furthermore, smaller companies with less than €250m of outstanding debt are more exposed – 18.6% of them had private credit estimates of ‘ccc+’ or below compared with 13.2% of private companies with between €250m and €1bn debt outstanding.
It was always S&P’s view that the default rate over the past two years was artificially depressed by the accommodating behaviour of senior lenders more interested in minimising book losses while at the same time capitalising on amendment fees and higher spreads. Their justification was that debt maturities for many of the legacy LBOs originally financed in 2006-2008 were still way off in the future toward 2013-2014 and that low interest rates meant that the cost of servicing debt interest was manageable for most businesses, even those that were underperforming.
Many Private Credit Estimate Companies Face Debt Restructuring
Over the past two years many speculative-grade companies – with reasonable operating performance and leverage, and that have public ratings and access to debt capital markets – have been proactive in improving their liquidity position by tapping into the liquid speculative-grade bond market to term out any debt maturities coming due over the next two years.
Other more difficult credits have found it more challenging to refinance bank debt in the bond market. Ineos Group Holdings and Seat PagineGialle are good examples of other tactics being adopted to address their leverage, namely asset sales and restructurings, respectively.
In contrast, most companies with private credit estimates are heavily reliant on either internally generated cash flow or debt financing from leveraged counterparties, namely banks and CLOs. Yet, banks currently face the challenges of higher funding costs and a more demanding regulatory environment.
Existing CLO investors, meanwhile, will have declining capacity to refinance debt of their portfolio companies as they reach the end of their reinvestment periods by 2014. Therefore, in S&P’s view many of the most vulnerable companies have little choice but to trundle on relying on senior lenders to amend covenants as required and to hope that economic and debt market conditions will improve sufficiently to facilitate a viable refinancing before going-concern issues arise.
S&P believes many of these most vulnerable companies will require debt restructurings a year or more before their term debt matures in 2013-2014. Indeed, as of the end of December 2011, almost 50% of S&P’s private credit estimate portfolio had scores of b- or ccc, up from 45% at the end of 2010. A substantial portion of about 55% of the 167 credit estimates that have defaulted since the end of 2007 remain highly vulnerable to defaulting again, meaning that they have a credit estimate of b- or lower. Consequently, combining both quantitative and qualitative factors into their assessment, and taking account of the more challenging economic outlook for the next one to two years, S&P has slightly revised upward its corporate default projections for 2012.
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