Close Brothers warns of rising default rates based solely on lower grade issuance, regardless of forthcoming economic conditions

London, 4 December 2006 – Close Brothers, a leading independent European corporate finance house, has conducted research showing that in addition to the growth of the European high yield market from 2003 to 2006, there has been a sharp increase in the issuance of riskier CCC-rated debt.  Given the high proportion of CCC-rated bonds which have historically defaulted, the Close Brothers research points to a tide of rising default rates significantly higher those seen in the past few years.

In 2003 just over €17 billion of high yield bonds were issued in the European Union. In 2005, high yield bonds issuance reached €19 billion and in 2006 that figure is on course to grow to €30 billion. But it is the issuance of CCC-rated bonds that is particularly notable.  In 2003 only 2.7% of high yield bonds issued were CCC rated (circa €0.5 billion).  In 2005 this figure escalated to 11.6% (circa €2.2 billion) and for 2006 it is on course to be 11.0% (circa €3.3 billion).

Over the past two years increasing amounts of high yield bonds have been downgraded to CCC-rated bonds, further ballooning the issuance figures (above), with the cumulative CCC-rated bonds in Europe now in excess of €14.5 billion.

As one third of CCC-rated bonds have historically defaulted after two years, with 44.7% defaulting after three years, Close Brothers predicts default rates will start to pick up naturally from 2007-2008.

Commenting on these findings, Matthew Prest, a Director at the Close Brothers Special Situations Group, said:

“This is a huge rise in the issuance and overall growth of lower quality bonds.  Even if overall macro-economic conditions remain benign the historic default rates of CCC-rated bonds point to problems ahead.  Many struggling companies will not be able to continue refinancing their way out of trouble as has been the trend of recent years.”

Over the past five years, the benign economic conditions and liquid debt markets have allowed companies in danger of breaching covenants to refinance their existing debt. 

If, as expected, the debt markets tighten in 2007/2008 a growing percentage of the high yield bonds maturing in 2007 and 2008 will face difficulty being refinanced.

Prest comments:

“This will lead to an escalation in stressed and distressed situations.  Corporate restructurings will increase and with the increased layers of debt that now exist in many company capital structures, combined with cross-border legal issues, these situations will be highly complex.

“Bondholders will look to recoup their losses and if that means debt-for-equity swaps then we’ll see a lot of companies changing ownership with follow on deal activity spurred by a wave of mergers and acquisitions.”

Another market fundamental that points to increased risk is the rising price spreads of BBB credits. These have increased from 72 basis points in October 2005 to 95 basis points in October 2006.

Enquiries:

Justin Clark

Close Brothers Corporate Finance

+44 (0)20 7655 3784