Thursday August 9, 2007 - 10:33:35 GMT
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Lloyds TSB Financial Markets - www.lloydstsb.com/corporatemarkets
Credit Market Analysis: Credit conditions have deterioratedCredit Market Analysis 8 August 2007
Credit conditions have deteriorated
The era of cheap money is over...
The era of cheap of money is behind us and without it comes the increased likelihood of a rise in corporate default rates and an end to the debt-financed M&A boom. Recent weeks has seen a significant rise in credit spreads. The European iTraxx main index has risen more than 150% since mid-June, as a result of increased demand for credit derivatives to hedge against higher potential defaults, see chart a.
Cash corporate spreads have also widened over the same period, though to a lesser extent, hence raising the cost of capital in the corporate sector. UK government bond yields have recently declined from multi-year highs, due to a flight to quality, but they remain significantly higher than last year - see charts b and c.
...yet corporate default rates remain low
Corporate default rates remain very low, as chart d shows. This is partly because global economic growth remains strong, hence boosting profits, so making default less likely. However, low interest rates and high levels of liquidity in recent years have also enabled some companies, which otherwise may have defaulted, to refinance and restructure their debts, including weak covenants.
But default rates are set to rise...
One consequence of the period of easy money is that credit and loan quality deteriorated, partly fuelled by increased leveraged buyout activity and the resultant releveraging of balance sheets. Chart e shows the UK capital gearing in the corporate sector has risen sharply in the last 7 years.
With interest rates and credit spreads now higher, corporate default rates will eventually begin to rise, even if global economic fundamentals remain sound, as we expect. This is what we are likely to witness in the coming quarters. Moody's predicts the global default rate will rise to 3.4% by mid-2008, in spite of continued robust world economic growth - see chart f. With credit spreads now returning to more normalised levels, we believe that this forecast is a realistic one.
... and the risks may be skewed to the upside
The next Credit Market Analysis will look at the risks to this central forecast of moderately rising default rates, especially if credit spreads widen more than projected. Further, the rise in leverage in the UK corporate sector has left it more vulnerable to external shocks.
Hann-Ju Ho, Senior Economist
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE,
0207 626 - 1500
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