A Gauge of the Weakest Issuers Shrinks for the Wrong Reason

  • Moody’s U.S. speculative-grade list falls as defaults increase
  • Pain to spread to non-commodities sectors, Deutsche Bank says

The first "significant decrease" in its portfolio of U.S. speculative-grade companies in almost three years is no reason to celebrate, according to Moody’s Investors Service. That’s because defaults were the main reason companies fell off the list.

The number of companies rated B3 negative and lower shrank to 283 as of June 1, from an all-time high of 291 on April 1, according to a Moody’s report released Monday. Rather than signaling improved credit conditions, according to the note’s authors including David Keisman, the drop portends more pain for junk-rated firms, particularly in the commodities sector, where prices remain stubbornly low amid concerns over excess supply. The list had grown back to 289 by July 1, the authors note.

"When you have oil and gas and other commodities, that alone will make sure that the U.S. corporate default rate will go higher," Keisman, a Moody’s senior vice president and note co-author, said in a phone interview.

Oil and gas companies represented 27.7 percent of Moody’s lower-rated portfolio, outweighing the other 26 industries it tracks. The credit-rater raised its forecast year-end U.S. speculative-grade default rate to 6.4%, up from 5.1% in June.

‘Not Negligible’

Investors hungry for yield seem undeterred by concern for an overheated junk market, with demand climbing in recent weeks as the number of negative-rate bonds worldwide rose to more than $11 trillion. Last week, investors piled on $4.5 billion in orders for a $375 million note from oil-change operator Valvoline Inc., pushing rates down to a one-month record low of 5.5 percent for a junk-rated company. Mutual funds that buy speculative-grade notes received $4.35 billion of deposits last week, the biggest inflow they received since $4.97 billion of deposits in the week ended March 2, according to data provider Lipper.

This trend has high-profile debt investors from Bill Gross to Howard Marks worried that the clamor for yield is leading buyers to disregard their riskier nature, allowing deeper problems in the asset class to go unnoticed.

"This rally has taken place despite a growing body of evidence that the credit cycle has most likely turned the corner in recent months, with defaults now beginning to materialize in sectors outside of commodity production," Deutsche Bank AG strategists Oleg Melentyev and Daniel Sorid wrote in a note on July 15. Though non-commodities defaults remain small, those numbers are "not negligible anymore and rising consistently."

U.K. Vote

Deutsche Bank said it expects the non-commodity sector default rate to reach 4 percent by late this year or early next, and reach 5 percent in "the next year or so." The commodities-sector default rate is projected to rise to 25 percent, from an earlier forecast of 20 percent, in the next few months, according to the report.

The surge of interest in U.S. high-yield corporate debt is partly attributable to last month’s U.K. vote to leave the European Union, after which global yields dropped to record lows. Total returns on EU high-yield credit lag those of the US by 137 basis points, according to the Deutsche Bank report, as the hunt for yield continues.

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