Signs of contagion in credit from oil and gas defaults
A new report by Moody's highlights that the high default rate in the oil and gas sector is beginning to impact on the broader high-yield market. Previously, slow-but-positive US growth supported corporate cash flow and helped to prevent commodity weakness from spreading to other areas, however, Moody's now says that the "commodity-driven climb in defaults is contributing to an increase in investor risk aversion and borrowing costs,” creating a Catch-22 scenario; more expensive short-term borrowings for speculative-grade (high-yield) companies to resolve liquidity issues is likely to increase the risk of defaults spreading, exacerbating investor risk aversion. Moody’s SVP, John Puchalla, points out that "our default risk indicators continue to weaken, warning that the existing upward default pressure will increase if the U.S. economy falters and investor risk aversion grows."

An earlier version of this article mistakenly described Moody’s default rate forecast for U.S. high-yield companies as the rate for the oil and gas sector alone. It has been corrected.

The high default rate in the oil and gas sector after a long period of low oil prices is starting to hurt the broader high-yield market, according to a new report from Moody’s.

Until now, slow-but-positive U.S. growth has been a support for corporate cash flow and helped prevent commodity weakness from spreading to other sectors.

Read:Company defaults headed for largest cyclical rise since recession

“But the commodity-driven climb in defaults is contributing to an increase in investor risk aversion and borrowing costs,” said analysts led by Moody’s Senior Vice President John Puchalla.

It’s a classic Catch 22 situation. Defaults are making investors nervous and that is making it more expensive for speculative-grade, or high-yield, companies to borrow short term to resolve liquidity issues. That’s because investors demand higher premiums for the extra risk they are taking on. And that in turn presents risks to the economy and makes if more likely the default risk will spread.

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“Our default risk indicators continue to weaken, warning that the existing upward default pressure will increase if the U.S. economy falters and investor risk aversion grows,” said Puchalla.

Moody’s is now expecting the U.S. speculative-grade default rate to climb to 6% by year end, the highest level since July 2010. That matches the rate expected by Fitch Ratings, which until now had the gloomiest outlook of the three major rating agencies.

In the first quarter, low commodity prices pushed the default rate to 4.1% from 3.2% in the fourth quarter. In May, the rate is likely to climb above the 4.7% long-term average that has been in place since 1990.

““Because lower-rated issuers are less able to weather through a period of weak earnings and liquidity pressure, default rates increase as ratings decline.”” — Moody’s Investors Service

“The default risk tug-of-war is playing out amid a backdrop where the rating profile of spec-grade companies is weak,” said the report.

The number of high-yield companies with a rating of B3 or lower is already above the levels reached in the last recession. A B3 rating is six notches below investment grade. The share of those companies at that rating rose to about 37.2% in the first quarter from 35.3% at year end, above the prior peak of 32.5% hit at the end of 2009.

“Because lower-rated issuers are less able to weather through a period of weak earnings and liquidity pressure, default rates increase as ratings decline,” said the report.

The weak rating distribution is a signal of a worrying default rate cycle should the economy slow or leveraged borrowing becomes more expensive.

The bulk of the indicators that Moody’s uses to measure credit quality are currently flashing warning signals. The liquidity stress index, which measures the number of companies that carry Moody’s lowest liquidity rating, hit 10.2% at end-March, well above its long-term average of 6.7%. The index rises when more issuers are placed in that category, and it falls when liquidity improves.

Read:Stress in oil credit market hits record level

The agency currently counts 207 companies with a rating of B3 or lower, also well above the long-term average of 184. The default rate stood at 5.7% at end March, also above its long-term average of 4.7%.

The only indicator that is improving is the covenant quality index, which measures the degree of protection afforded to holders of high-yield, bonds sold by North American issuers. That index has a scale that runs from 1.0 to 5.0, where a lower score is a sign of stronger covenant quality, and a higher score is the opposite. It fell to 4.26 in March from 4.34 a year earlier. The long-term average is 3.98.

Read: Corporate defaults are on the rise, with 3 more this week

There were 23 U.S. non-financial corporate defaults in the first quarter, up from 16 in the fourth quarter, the most since the third quarter of 2009. While commodity companies accounted for the bulk of those, liquidity and default pressures are gradually rising in other sectors, although the pace of non-commodity defaults hasn't changed materially.