Default rate breaks new record

The high yield market is set to significantly outperform investment grade corporate bonds for the fourth consecutive year. By far the biggest driver of performance over not only this year, but the last four years, has been a plummeting default rate. Strong global economic growth has translated into profitable companies with healthy balance sheets, and as a result there have been very few companies that have missed their loan repayments. Click on the image to the left to view global high yield default rates.

The picture in Europe has been particularly rosy. Since February 2005, just three companies have defaulted, out of around 140 companies in Europe with bonds rated sub-investment grade. But before everyone rushes out to buy the lowest rated, highest yielding bonds they can find, it’s worth pointing out that all three of these defaults have taken place in the last six months. One company was Eurotunnel, which is restructuring, while the other two were manufacturers in car parts (GAL is a French company that supplies parts to Renault, while Dura is US-based and manufactures parts for GM and Ford). Auto parts companies have really felt the heat this year as a result of major production cutting by the big car manufacturers – in the US, there have been a number of defaults in the sector, including Delphi, GM’s largest supplier.

I’m not overly concerned with the recent pick up in the default rate at the moment. There are very few companies “in distress”, which is defined as a bond yielding at least 10% more than a government bond. Those that are in trouble are concentrated in the auto part sector (which I’ve avoided). The big risk to the market over the medium to long term is that the global economy slows sharply next year, as this would start putting pressure on those companies that are already highly leveraged or are struggling with high production costs.

Graph source: Moody’s Default Report, end November 2006