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A Bad Start to 2001

As expected, default rates in 2001 are outpacing those of 2000. Annualized, the default experience of the first quarter already approaches the dismal performance of recessionary 1991.

Worldwide, 48 companies defaulted on $37 billion worth of rated long-term debt in the first quarter, making it, by far, the worst ever. To put this in perspective, we must keep in mind that this total already represents 87% of the record $42.3 billion in defaulted debt for all of 2000. Just four companies -- Indonesia's Asia Pulp & Paper Ltd., Finova Capital Corp., and the California utilities Pacific Gas & Electric Co. and Southern California Edison Co. -- contributed more than $22 billion to the quarter's tally. A performance this dismal is extremely unusual and it is highly unlikely that dollar defaults will keep this pace for the remainder of the year.

Apart from one company each in Bermuda, Indonesia, and the Philippines, and four more in Canada, the defaulting companies were located in the U.S. Only four of them had ever held an investment-grade rating. The rest were initially rated in the speculative-grade ranks. In fact, 84% of them had never received a rating higher than 'B+'.

Defaults in units, however, might keep pace with those of the quarter just passed. Were this to happen, we would be looking at speculative-grade defaults in the neighborhood of 9% this year. More realistically, though, we might end the year with 170 defaulted companies, which would place speculative-grade defaults and investment-grade defaults at 8.3% and 0.3%, respectively, for the year.

How bad things get will depend on how severe the current economic slowdown turns out to be. Nobody has dubbed it a recession??ften defined as two consecutive quarters of economic contraction??et, but most observers seem to believe that we are definitely entering one.

The picture, however, is still fuzzy. Citing uncertainties about the business outlook, the Federal Open Market Committee cut key U.S. interest rates by half a percentage point as we went to press. The unexpected rate cut came the day after the Federal Reserve revealed that industrial production in the U.S. had risen 0.4% in March, the first increase since September and the largest since August. Economists, who had expected a drop of 0.1%, were quick to interpret the unexpected rise as a sign that a recession might be averted after all. The new interest rate cut will, no doubt, strengthen that sentiment.

News accounts indicate that the profits of U.S. companies dropped 9% in the year's first quarter. Expectations are that they will decline another 7% in the second quarter and barely keep above water in the third.

The fear is that these anemic profits will impact employment. Recent statistics indicate that nonfarm jobs fell by 86,000 in March, the largest one-month drop in a decade. At the same time, the jobless rate reached 4.3%, a high not seen in 18 months.

Consumer demand has until now given hope to the manufacturing sector. Buoyed by lower interest rates, autos and residential construction have more than offset the obvious sluggishness of the high-tech sector. But it is doubtful that consumption expenditures will remain unaffected in the face of mounting employment and stock market losses.

Back when the stock market was surging, consumer spending would not let up and this helped to keep the boom going. But now, after the massive destruction of wealth of the past year and the daily dose of news announcing layoffs, consumers seem to be showing the first signs of restraint. Recently released figures showed that U.S. retail sales, flat in February, had actually slipped by 0.2% in March.

This cannot be good news for business, coming on top of reports that banks have continued tightening lending standards and that credit spreads are still widening, specially for the weaker players (see chart 2). At the same time, IPOs, which raised more than $300 billion between 1993 and 2000, have all but dried up.

Cut off from these alternative funding sources, U.S. corporates floated 299 new straight bond issues in the first quarter of 2001, for a record $150 billion. This represents a 270% jump over the last quarter of 2000. Of this dollar amount, 80% corresponded to investment graders (220 issues) and 20% to high-yield companies (79 issues).

In terms of credit quality, there were 313 global rating actions during the first quarter of 2001, 70 of them upgrades and 243 downgrades. They affected, respectively, $88 billion and $398 billion of rated debt. The ratio of global upgrades to downgrades continued its precipitous slide of the last few years. It was 0.29 in the year's first quarter, down from 0.35 in 2000, 0.39 in 1999, 0.50 in 1998 and 1.0 in 1997. Merger and acquisition activity continued to represent a less significant proportion of overall rating actions than was the case in the past.

As indicated above, high-yield issuance merely reached 20% of total issuance in the first quarter, down from 50% for all of 2000 and 60% in 1999. Although in time this will improve the overall quality of the rating mix, the fact remains that there are still many weak companies out there, saddled with onerous debt burdens. They will encounter, no doubt, trying times ahead. From Standard & Poor?? RatingsDirect

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