Cash & Liquidity ManagementInvestment & FundingCapital MarketsGrowth Spurt for First-Time Issuers in U.S. High-Yield Bond Market

Growth Spurt for First-Time Issuers in U.S. High-Yield Bond Market

Growth in new bond issues in the U.S has been fueled by excellent supply conditions-characterized by historically low Treasury rates and tight bond spreads-which combined with strong demand by investors has generated impressive activity in this market. Indeed, prompted by favorable demand and supply conditions, the number of issuers approaching the high-yield bond market for the first time (both for ratings and issuance) doubled in 2003 compared with its level in the two previous years. Since 2001, the number of U.S. “firsttime” high-yield issuers (this term will be used to refer to first-time rated/first-time issuing in the remainder of this report) has doubled, bringing the total for 2003 to 77. At 77, the pool of “first- time” high-yield issuers still remains way below the annual peak of 256 seen in 1997. Average issuer credit ratings among these “first-time” issuers, generally falls around the ‘B+’ level (which generally corresponds with ‘B-‘ ratings at the issue level). This rising influx of lower-rated issuers into the U.S. speculative-grade market spells caution for credit quality and defaults down the road. When the share of lower-grade issuance (particularly at the ‘B-‘ level or lower) exceeds 30% for a sustained period of time, it generally serves as a reliable indicator of imminent default pressure two to three years ahead.

Many of the first-time issuers in 2003 came from the consumer products, health care, and media & entertainment sectors. Within consumer products, some lower-rated issuers pursued a releveraging strategy in 2003, issuing debt on the strength of their business franchise and consistent cash flows. New issue activity in the gaming subsector of the media & entertainment sector experienced growth both from the expansion of Native American casinos, and from the new financing needs of sponsor-led divestitures of established companies. Demand for new issues in the healthcare sector stems from the anticipated future growth among healthcare service providers. New issuance rated at ‘B-‘ issue level and below is also being fueled by refinancing among telecommunications issuers.

Credit quality in the U.S. speculative-grade market improved in 2003, notwithstanding the healthy pipeline of new issues. The U.S. speculative-grade downgrade ratio-downgrades to total rating actions-improved to 73.1% in 2003. In the short-term, the U.S. speculative-grade default rate-which fell to 5.4% in January from 7.6% at the end of 2002-reflects improving credit conditions. The gradual decline in defaults will persist through 2004, drifting below the U.S. speculative-grade long-term average default rate of 5.3%. Credit quality is likely to continue

to improve as current Outlook and CreditWatch implications suggest a reduction in downward credit quality pressure in tandem with greater ratings optimism. The share of issuers with negative Outlook and CreditWatch implications fell to 31.7% in 2003 from 37.2% at the end of 2002. Meanwhile, positive Outlook and CreditWatch implications rose to 11.2% from 10.0% over the same period. Sectors with continued credit challenges within the speculative-grade universe include capital goods and utilities, each with 40% of issuers or more having either a negative outlook or on CreditWatch with negative implications. Upgrades are more likely to emerge from wireless telecommunications and real estate with 25% of issuers or more have either positive outlook or on CreditWatch with positive implications.

Chart 1. Monthly Issuance in the U.S. Speculative-Grade Market

Includes all public, private (outside U.S.) and rule 144a issuance of straight debt, convertible debt, floating-rate notes, and
medium-term notes by financial and non-financial entities. Data as of February 4, 2004.
Source: Standard & Poor’s Global Fixed Income Research, Thomson Financial

New Issuance

U.S. speculative-grade rated issuance soared in 2003, recording US$122 billion in issuance, more than double the amount recorded in 2002 with US$57 billion. This was the most speculativegrade issuance in the U.S. marketplace since 1998 when US$123 billion was recorded. 2004 is poised to challenge these highs provided the speculative-grade issuance of US$10.6 billion recorded in January this year maintains its pace in the rest of the year.

Chart 2. U.S. Speculative-Grade Issuance by Sector

Includes all public and rule 144a issuance of straight, convertible, floating-rate, and medium-term notes issued into the U.S.
marketplace by financial and non-financial entities. Data as of February 4, 2004.
Source: Standard & Poor’s Global Fixed Income Research, Thomson Financial

The issuance in 2003 can partially be attributed to 77 “first-time” bond issuers, up from 47 in 2002. On average, “first-time” issuers came to market with issuer credit ratings averaging near ‘B+’ in 2003, down from 2001 with an average of ‘BB-‘. The greatest number of these “firsttime” issuers came from the industrial sectors of consumer products, healthcare, and media & entertainment. With 225, the peak in new “first-time” bond issuers was in 1997, when consumer products and media & entertainment led the pack.

Of the new issues in 2003, 7% were financial, 73% industrial, 10% telecommunication, and 11% utility (Chart 2). Media & entertainment, telecommunications and utilities experienced the greatest increase in speculative-grade issuance in 2003 compared to 2002. These same sectors are leading the surge in 2004, each coming to market with more than US$1 billion (Chart 3).

Table 1. U.S. Speculative-Grade New Issuance Distribution by Rating

*Data as of February 4, 2004.
Source: Standard & Poor’s Global Fixed Income Research; Thomson Financial.

As was the case in 2003, the sustained low interest rate and declining credit spread environment continues to limit investors’ options for higher yields. In turn, this has led to continued investor willingness to purchase lower credit quality issues. Issuance at the lower credit rating category of ‘CCC’ rose to 19% of total speculative-grade issuance in 2004, up from 8% in 2003. The surge in the share of ‘CCC’ rated new issuance is attributable to the telecommunications sector. On the flip side, issuance of ‘BB’ rated bonds decreased to 52% of total speculative-grade issuance in 2004, down from 64% for all of 2003 (Table 1 & Chart 4).

Chart 3. U.S. Speculative-Grade Issuance by Subsector

Includes all public and rule 144a issuance of straight, convertible, floating-rate, and medium-term notes issued into the U.S.
marketplace by financial and non-financial entities. Data as of February 4 for each year.
Source: Standard & Poor’s Global Fixed Income Research, Thomson Financial Aerosapce & Def.-Aerospace & Defense; Chem, Pack & ES-Chemicals, Packaging & Environmental Services; Int. Oil & Gas- Integrated Oil & Gas; Media & Ent.-Media & Entertainment.

Chart 4. U.S. Speculative-Grade Issuance by Rating

Includes all public and rule 144a issuance of straight, convertible, floating-rate, and medium-term notes issued into the U.S.
marketplace by financial and non-financial entities. Data as of February 4, 2004.
Source: Standard & Poor’s Global Fixed Income Research, Thomson Financial

Chart 5. U.S. Speculative-Grade Issuance by Maturity

Includes all public and rule 144a issuance of straight, convertible, floating-rate, and medium-term notes issued into the U.S.
marketplace by financial and non-financial entities. Year-to-date data as of February 4, 2004.
Source: Standard & Poor’s Global Fixed Income Research, Thomson Financial

The increased proportion of lower-grade issuance has had little effect on maturity in 2004. Of the proceeds raised this year in the U.S. speculative-grade market, 83% have maturities of more than seven years compared with 81% for full year 2003 (Chart 5).

U.S. speculative-grade credit spreads retreated visibly (Chart 6) in 2003 buoyed by strong investor demand, tumbling default rates, and overall improvement in credit fundamentals. Declining volatility in VXO hints that aggregate spread levels may have bottomed. As of Feb. 12, 2004, speculative-grade credit spreads among U.S. non-financials were 462 basis points, above the 444 basis points recorded on Dec. 31, 2003, but still well below the 815 basis points recorded on Jan. 2, 2003. Speculative grade volatility has currently declined to 24.5%, from fourth-quarter highs in 2003 of 30.0%.

The speculative-grade rating categories ‘BB’, ‘B’, and ‘CCC’ tightened 165 basis points, 171 basis points, and 317 basis points, respectively for an average tightening of 31% over the past seven months. Though spread tightening was observed across the speculative-grade rating categories, no parallel trend in volatility was evident. However, the higher quality end of this rating spectrum indicates declining volatility whereas ‘CCC’ volatility is on the rise.

Chart 6. U.S. Non-Financial Speculative-Grade Downgrade Ratio & Credit Spreads

Non-Financial includes industrial, telecommunications, and utility sectors. Data as of February 12, 2004.
Source: Standard & Poor’s Global Fixed income Research

Rating Actions

Credit quality in the U.S. speculative-grade segment has broadly been on an improving trend. Since peaking at 91% in the fourth quarter of 2001, the downgrade ratio (downgrades to total rating actions) dropped to 72% in the final quarter of 2003. For 2003, an average ratio of 73% was recorded, down from 81% in 2002 (Chart 7). In the year to date (ending Feb. 12, 2004), seven upgrades and 28 downgrades have been recorded, affecting rated debt worth US$3.9 billion and US$25.4 billion, respectively.

Of the U.S. 35 speculative-grade rating actions so far this year, 31 (88%) were in the industrial sector, three (8.8%) were in the financial sector, and one (2.9%) was in the telecommunications sector. The hardest hit by downgrades so far in 2004 is chemicals, packaging & environmental services, with six downgrades. Automotive and consumer products were next, each recording four downgrades.

Chart 7. U.S. Speculative-Grade Bond Downgrade Ratio vs Real GDP

Downgrade ratio is calculated as the number of speculative-grade downgrades divided by the total number of speculativegrade
rating actions. Downgrade ratio includes financial, industrial, telecommunication, and utility sectors. Downgrade ratio
data as of February 12, 2004.
Source: Standard & Poor’s Global Fixed Income Research, Bureau of Economic Analysis

Reflecting an improving credit environment, there were fewer fallen angels in 2003 than in 2002 -these are issuers whose ratings fell into the speculative-grade rating category (‘BB+’ and below) from the investment-grade rating category (‘BBB-‘ and above) (Chart 8). In 2003, there were 34 U.S. fallen angels (US$42.6 billion) compared to the record high 50 fallen angels (US$155.0 billion) for full 2002.

Additionally, 2003 also saw more rising stars-these are issuers whose ratings rose into the investment-grade rating category (‘BBB-‘ and above) from the speculative-grade rating category (‘BB+’ and below). 14 “rising stars” were recorded in 2003 affecting rated debt worth US$11.1 billion compared with 10 in 2002 affecting US$12.7 billion. So far in 2004, three fallen angels and two rising stars have been recorded, affecting debt worth US$2 billion and US$925 million, respectively.

Chart 8. U.S. Rising Stars & Fallen Angels

Source: Standard & Poor’s Global Fixed Income Research

U.S. Speculative-Grade Rating CreditWatch and Outlooks Credit quality in the U.S. speculative-grade segment is likely to improve. The current Outlook and CreditWatch distribution2 suggests a reduction in downward credit quality pressure in tandem with greater ratings optimism. The share of issuers with negative Outlook and CreditWatch implications fell to 31.7% in 2003 from 37.2% ending in 2002. Meanwhile, the share of positive Outlook and CreditWatch implications rose to 11.2% from 10.0% over the same period. As of Feb. 9, 2004, the distribution of speculative-grade issuers on CreditWatch showed 28% positive, 67% negative, and 5% developing (Chart 9). Meanwhile, the distribution of Outlooks for speculative-grade entities showed 10% positive, 29% negative, 60% stable, and 1% developing (Chart 10). The retail/restaurant sector displayed the greatest vulnerability for potential downgrades, with 38% of its issuers having a negative outlook, 44% stable, and 17% positive.

Chart 9. U.S. Speculative-Grade Outlook Distribution by Sector & Industrial Subsector

Outlooks measured at the parent level. Issuers on CreditWatch excluded. Data as of February 9, 2004.
Source: Standard & Poor’s Global Fixed Income Research

Chart 10. U.S. Speculative-Grade CreditWatch Distribution by Sector & Industrial Subsector

CreditWatch measured at the parent level. Issuer Outlooks excluded. Data as of February 9, 2004.
Source: Standard & Poor’s Global Fixed Income Research

U.S. Defaults

U.S. default rates declined to 5.39% at the end of January 2004, approaching the long-term (1981-present) average of 5.17%, compared to a rate of 7.44% at the end of 2002. The decline in the speculative-grade default rate has been accompanied by an easing of lending conditions, as reported in a recent survey conducted by the U.S. Federal Reserve. Falling default rates are among the factors that have facilitated spread compression, thereby enhancing issuance conditions in the speculative-grade bond market. Evidence that economic strength is being rebuilt and corporate profitability is improving implies a more sanguine outlook for defaults in the near term. Still, the rising proportion of lower-grade issuance (‘B-‘ or lower) to the total in the U.S. serves as an early warning of renewed default pressure two to three years ahead.

A total of 73 defaults were recorded in the U.S. in 2003 on rated debt outstanding of US$40.5 billion. As of February 9, 2004, a total of 29 entities still remained vulnerable to default. These “weakest link” issuers are defined as issuers that carry a credit rating of ‘CCC’ or lower and are listed either with a Negative Outlook or a CreditWatch with negative implications. The current list of 29 is four fewer than the number reported in our January 9, 2004 commentary.

Table 2. U.S. Subsector Distribution of Weakest Rated Issuers

Weakest rated issuers are defined as issuers that carry a credit rating designation of ‘CCC’ or lower and are listed either with a Negative Outlook or a CreditWatch with negative implications. Data as of February 9, 2004. Source: Standard & Poor’s Global Fixed Income Research

By sector, media and entertainment, consumer products and retail/restaurants continued to show the highest vulnerability for default among the U.S. “weakest links” (Table 2). Of the 29 issuers on the most recent list, five were from media and entertainment, and four each were from consumer products and retail/restaurants. The three sectors together accounted for 45% of the total. This concentration is in part the outcome of a heavy spate of issuance in 1997-99 at the lower rungs of the rating spectrum (‘B-‘ and below).

In the U.S., the share of new issue volume by issuers rated ‘B-‘ and lower has increased in 2004 despite a downtick at the end of 2003 as a proportion of total speculative-grade issuance (Chart 11). This share increased to 45.9% this year from 29.4% in the fourth quarter of 2003. The share for the third quarter of 2003 was 35.4%. Issuance generated at the ‘B-‘ level and lower on the rating spectrum is typically a breeding ground for potential defaults. The previous spike in lowgrade issuance at these rating categories during 1997-99 subsequently led to a peak in defaults in 2001. During this period, the share of speculative-grade companies with issuance rated ‘B-‘ or lower consistently exceeded 30%. If the current proportion remains above the 30% range for a sustained period of time, it will serve as an early warning that the speculative-grade default rate could worsen in three years, which is typically the length of time between elevated issuance and higher defaults.

Chart 11. U.S. Speculative-Grade Issuance vs Default Rate

Default rates are 12-month rolling averages. Default data as of January 31, 2004. Includes all public and rule 144a issuance of straight, convertible, floating-rate, and medium-term notes issued into the U.S. marketplace by financial and
non-financial entities. Issuance as of February 4, 2004.
Source: Standard & Poor’s Global Fixed Income Research/S&P Risk Solutions CreditPro®/Thomson Financial

1 Count includes actions on financial, industrial, telecommunications, and utility sectors

2 Standard & Poor’s CreditWatch indicates the potential direction of a credit rating change, dependent on identifiable events and short-term trends, and is typically resolved within 90 days. A rating outlook indicates the potential direction of a credit rating change within six months to two years.

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