Credit markets continue to improve sharply, however, a still climbing speculate grade default rate continues to forecast a very tepid recovery.  A recent report from S&P shows that the distress ratio has improved substantially and recently fell to pre-Lehman levels:

Continuing its descent in 2009, Standard & Poor’s distress ratio has hit another low this year, reaching 23.5% as of Sept. 15, down from 25.3% in August. The decrease in distress is coincident with movement in corporate bond spreads. Distressed credits are speculative-grade-rated issues that have option-adjusted spreads of more than 1,000 basis points (bps) relative to Treasuries.

The bank, insurance, media and entertainment, and high technology sectors are posting distress ratios in excess of their traditional, issue-based distress measures.   Following alongside the recent activity in the corporate universe, distress in leveraged loans has experienced a slight decrease as well, with the S&P/LSTA Leveraged Loan Index distress ratio falling to 31.1% in August from 34% in July.  Among distressed bonds, the total number of companies with issues trading with spreads of 1,000 bps and higher is currently 193, down from 208 in August.

This has a potentially negative outlook for U.S. corporations going forward.   The high default rate implies that many of the debt troubles associated with the credit crisis are still negatively impacting business prospects.  This also confirms much of our thesis that the long-term Japan-like debt problems are likely to persist and hinder future earnings growth:

In September, 72% of all distressed issues fall into the lowest rating categories (’5′ or ‘6′), indicating only negligible to modest recovery in the event of default. In addition, 85% of all distressed issues are either unsecured or subordinated notes. Holders of those notes have claims to a firm’s assets that are secondary to more senior debtholders in the event of default.  With a decrease in the distress ratio, the amount of affected debt also fell–to $101.9 billion from $116.4 billion in August.

Recent research from CreditSights confirms the slow recovery thesis and actually shows that the recovery in Europe is likely to be substantially slower than the domestic recovery.  CreditSights came up with the following important highlights:

• The current default cycle has been severe, with default levels in the US on track to rival those seen in the 1990/1991 recession;

• In Europe, the market is pricing in a level of default close to that seen in the 2001/2002 default cycle;

• As a result of improving market conditions, default forecasts for 2010 and beyond have been downgraded significantly.

• In the US, BondScore confirms that the worst is most likely over, but it is unlikely that default rates will get back to their pre-crisis levels any time soon;

• In Europe, BondScore projections show that default rates of public bond issuers are likely to peak within the next 3-6 months at a level well below the 2002 peak, as the lion’s share of European defaults is likely to come from the private leveraged loan universe.

Source: S&P, CreditSights

Cullen Roche

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