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High-risk debt boom sparks fears

January 15, 2007 | Financial Times

The amount of debt carrying the highest risk of default is rising as a proportion of the junk bond market, prompting fears the next cycle of corporate failures could be more severe than the last.

In the US, nearly 16 per cent of bonds are rated CCC or below; up from about 13.5 per cent at the end of 2005, as measured by the Merrill Lynch high-yield index.

High-yield or junk debt is rated below the BBB bracket, the lowest investment grade rating. Credit ratings of CCC or below are reserved for junk bonds with the highest risk of default.

The European market has also seen record issuance of CCC-rated paper.

Mahesh Bhimalingam, European high-yield strategist at Barclays Capital, said this was a “symptom of a booming market” in which credit of all kinds has become exceptionally cheap and plentiful.

But Mr Bhimalingam said there was cause for concern: “When the cycle turns and the environment is no longer benign, these lower-rated issues could be on the brink of defaulting.”

Abundant liquidity in global debt markets has helped push default rates and risk premiums to record lows and feed investor appetite for risky assets.

“I don’t think anyone seriously disputes that a lot of precariously financed deals have been sold into the market in recent years,” said Martin Fridson of research publication Leverage World.

The problem, he warned, is “liquidity is there when you don’t need it in the high-yield market”.

In other words, overstretched companies can survive by borrowing more in friendly markets, but sink when conditions turn sour.

Mr Fridson’s analysis suggests recent high levels of low-quality debt issuance could push default rates sharply higher – from fewer than 2 per cent of high-yield borrowers last year to as much as 17 per cent – if the US were to experience a recession.

Thus far, there are few signs of trouble. Distressed bonds in the US – those that trade with risk premiums of more than 10 percentage points over US Treasury yields – fell to an all-time low of 1.6 per cent of the junk-rated market in December, according to Standard & Poor’s, compared with an average of 6.1 per cent in 2005 and 7.4 per cent in 2004.

But low-quality issuance in recent years could sow seeds of future problems.

Diane Vazza, head of global fixed income research at S&P, said: “Although the near-term outlook for defaults is still relatively sanguine, a sustained period of increased lower-grade issuance since 2003 – both in the US and Europe – serves as a warning of more material default pressure ahead.”

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