Corporate Loan Defaults: A Rising Possibility In 2005

The corporate sector entered 2005 in good health. Most companies, particularly those in the sub-investment grade, took advantage of two years of sustained low interest rates to roll over and refinance their debt obligations. Many have also kept their operating costs low and have followed prudent business models. As a result, they have robust balance sheets and good levels of cash.

The improving health of the corporate sector has been reflected in the corporate default rate, which continued to trend lower throughout last year. The global corporate default rate stood at a low of 0.7% at the end of 2004, down from 1.7% in 2003, according to Moody’s Investors Service.

Banks responded by greatly easing lending standards through 2004, structuring and syndicating loans for less creditworthy borrowers. At the same time, investors in the public bond market were flush with cash and eager for high returns, buying successive bond issues from even the riskiest of corporate issuers. Even issuers in the very low Caa rating category have been able to issue debt (last year, nearly 16% of all new speculative grade issuers were rated in the Caa-C range).

However, the Federal Reserve is tightening rates. While this is gradual, it will have major repercussions for corporate borrowing. Lending banks are likely to cut back on liquidity, and mutual funds and other high yield investors could also pull back from the market as the potential for defaults increases.

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