Sizing Up a Credit-Market Recovery

Many investors believe that they've been able to discern the outlines of economic recovery in recent months. But the full picture that develops could prove less pleasing than they'd like. Standard & Poor's Global Fixed Income Research believes that the strength of the economic rebound will differ from those following other recent recessions.

Here, Diane Vazza, head of Standard & Poor's Global Fixed Income Research Group, answers some questions regarding what investors might expect as this recession enters its final stage.

What signs of a recovery do you see in the credit markets?

There are several signals that are consistent with the last stages of a recession. For one, among nonfinancial issuers, we're seeing declines in downgrades and in the negative bias, which is the proportion of issuers with a negative outlook or ratings on CreditWatch. Both have been falling since their recent peak in March of this year.

We also see a tightening of spreads as market worries about credit risk and liquidity risk have also eased since the fall of Lehman Brothers last year. In fact, the speculative-grade (BB+ or lower) corporate bond spread has closed by 928 basis points since its peak in December, and we've also seen improvements in the loan market.

Meanwhile, equity indices have also rallied significantly since the trough of the recession, though there's still some way to go to match their pre-recession highs.

Are there any other indications that this recovery is for real?

The bond market has sprung back to life. Investment-grade (BBB- or higher) nonfinancial corporate bond issuance has reached $291 billion year-to-date, and speculative-grade issuance has totaled $64 billion. Investment-grade companies are able to tap public markets easily. Higher-rated speculative-grade companies can also manage to refinance debt, though the cost remains high.

So is the worst over? Has credit quality bottomed?

It seems so. Credit quality tends to stabilize at, or nearly at, a recession's end, and the indicators we have seen point toward this. In addition to credit quality starting to improve, with a better ratings mix (the growing volume of defaulting debt is cleansing the pool of the weakest issuers), we can also see another sign of improvement: stronger profits. Corporate profits appear to have bottomed out in the last quarter of 2008, one quarter before the peak in downgrades. That's consistent with the previous two recessions.

In addition, based on public companies' reported earnings in the second quarter of 2009, positive earnings surprises are outpacing negative ones by a ratio of 1.9 to 1.

If this recovery is under way, will its pace and strength mirror previous ones?

Although we believe the credit markets have come out of their worst period in this cycle, we expect, for several reasons, that recovery this time around will be slower and less robust than in previous recessions. This recession has been one of the worst on record, with general economic indicators still rebounding from very low levels. Consumer spending remains muted, in part because of a lack of available credit. Unemployment is high. Moreover, on the production side, there's still plenty of spare manufacturing capacity.

In recent months, we've seen improvement in some of these indicators. But those improvements haven't always been steady, and we still expect slow growth as the recession ebbs, with real gross domestic product increasing only 1.5% in 2010.

What does that slow economic growth mean specifically for the credit markets?

The outlook remains dim for the weakest companies. We can't forget that more than 60% of all U.S. nonfinancial corporate debt is speculative-grade, and 26.4% of companies in this category are rated B- or lower; the mix of ratings on these companies at the start of this cycle was the worst on record.

Many of these issuers have depended on collateralized loan obligations (CLOs) and other structured securities, and we believe that these markets are now limited. Loan market volumes have typically constituted roughly 75% to 80% of speculative-grade borrowings in recent years. Yet in 2009 year-to-date, that share has dipped to only about 35%. The bond market has absorbed some of this volume—but far from all of it.

Covenant pressures also remain for speculative-grade issuers. We estimate that 26% of speculative-grade issuers remain at serious risk of breaching their covenants over the next six months. Without greater revenue, some of these companies could see liquidity dry up enough for them to consider filing for Chapter 11 bankruptcy.

Capital, even when available, also remains expensive for speculative-grade issuers. The overall yield-to-maturity is now 11.4% for B-rated bonds and 9.8% for BB-rated debt. Higher interest expense means that companies that must refinance will be at a disadvantage.

Finally, many companies are saddled with loan-heavy capital structures, which can potentially weigh down on their senior collateral. As a result, in the event of bankruptcy, recoveries associated with secured loans probably won't be as robust as we've seen in previous recessions.

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