Default Rates – Where Do We Go From Here?

Moody’s this week published its December 2006 default report showing a fall from 1.8% to 1.7% marking its fifth consecutive annual decline and its lowest year-end level since 1996. Accommodative monetary policy, high levels of liquidity and a willingness to come to the aid of companies in financial difficulty has helped keep rates at historical lows. Worldwide in 2006, a total of 27 Moodys rated corporate bond issuers defaulted on $7.8bn equivalent of bonds compared with 34 and $29bn the previous year. In fact in Europe a mere four corporates (Damovo (telco equipment), Dura & GAL (auto suppliers) and Luxfer (engineering)) defaulted on their obligations in 2006 to the tune of $1.2bn.

The obvious question then is where will the default rate head in 2007 and onwards? Moodys has 2.6% pencilled in for year end ’07 though they had been projecting a rise during most of 2006 and got that one wrong! I think the answer requires a two part explanation. Firstly the larger macro picture will prove to be key. If monetary policy remains accommodative through 2007 then liquidity is unlikely to disappear and prove supportive of a low default rate. Secondly the arithmetic behind the default calculation is worth a mention. The default rate during the early part of 2006 was particularly low. Even if we were to see default rates at the same pace of H2 2006 then the default rate is likely to tick up.

In my opinion the likelihood is that Moody’s will be proved correct. It doesn’t take a genius to conclude that the path of least resistance from a 10 year low is higher, but as ever, timing will be key!