Cuts will not protect firms from loan defaults

ANALYSIS:There has been a sharp rise in the cost of protecting against corporate default, writes Proinsias O'Mahony

EUROPEAN COMPANIES may be able to enjoy lower borrowing costs courtesy of rate cuts by the European Central Bank (ECB), Bank of England and Sweden's Riksbank, but credit markets suggest it will not be enough to prevent a record number of corporations defaulting on their loans as deepening economic problems take hold.

The cost of protecting European investment-grade corporate bonds from default soared to above 200 basis points for the first time yesterday.

The Markit iTraxx Crossover index, which measures the cost of protecting junk-grade companies against default - companies rated as more risky than their investment-grade counterparts - remained above 1,000 basis points, a level breached for the first time on Wednesday. This means it now costs more than €1 million annually to protect €10 million of debt issued by such companies over a five-year period.

Increasingly woeful economic data, coupled with growing fears as to whether companies will be able to refinance their debt, has resulted in a sharp rise in the cost of protecting against corporate default.

At the beginning of November, the iTraxx index was trading at approximately 700 basis points and the current figure is more than five times the level registered before the credit crunch began. When companies default on their loans, bankruptcy often follows.

In Japan, too, markets envisage a record level of corporate defaults, with Japan's iTraxx hitting new highs yesterday.

An index measuring 125 investment-grade companies in the US was trading just below the highs registered last month.

The highest percentage of defaults on record in the US occurred during the Great Depression in 1933, when 15 per cent of companies defaulted on their loans.

John Lonski, chief economist at Moody's Investors Services, said markets were currently implying a stunning default rate of 21 per cent on speculative-grade bonds.

It was confirmed this week that the US is in recession and has been for 12 months, making it the longest US recession in 26 years.

The weakening economic environment saw corporate defaults rise to 3.3 per cent in October, Lonski said. Defaults would "start rising quickly", breaking above 10 per cent by the end of next year. The paucity in financing options for riskier-rated companies was a "very big problem", he said.

Just $2.7 billion (€2.11 billion) of high-yield bonds have been sold this quarter, a far cry from the $30 billion registered in the same period last year.

The soaring cost of insuring against bond default indicates that investors have moved from obsessing about crisis in the financial sector to an increasing concern as to the rapidly deteriorating global economic outlook. Analysts at Unicredit, Italy's largest bank, said collapsing consumer confidence meant there was a 35 per cent chance of a global depression.

Scott Anderson, an economist at US bank Wells Fargo, said bond investors had moved from a "near-lackadaisical view of default risk a little more than a year ago to one of extreme panic and hypervigilance".

That point was echoed by Chris Williamson, chief economist at Markit, whose iTraxx indices measure the cost of insuring against default. "We're seeing growing fears that companies are going to simply go bust," says.

"This isn't just the financial markets - it's across a raft of other industries as well."

European credit markets were increasingly pointing to a "deep and protracted recession", Williamson said.