Moody's Investors Service will unveil today a default rate forecast of 9.5% for the junk market this year, and Credit Suisse First Boston is again taking the agency to task over its methodology. The heart of argument is over the relevance of macro fundamentals and the aging factor of bonds for predicting default rates, which Moody's maintains to key parts of determining forecasts. CSFB doesn't and is forecasting a high yield default rate of 5-5.5% for this year. The two players have a history of disagreeing, facing off last summer when the then Donaldson, Lufkin & Jenrette also came up with forecasts starkly different from the more bearish Moody's. "They are always bantering," says Ron Habakus, portfolio manager at Brown Brothers Harriman in New York. "CSFB along with Merrill Lynch have the most research on the sellside, and Moody's has all the default data--they're just vying for headlines," he adds.
In a recent research piece, CSFB argues the aging effect on bonds and macro economic drivers have both become less relevant tools for predicting default rates. In its Annual Default Study to be released today, Moody's argues the aging effect is an important tool among many for predicting defaults, and that macro economics is still relevant for understanding the economy.
The aging effect holds that at the time a company issues paper it is flush with cash and defaults are unlikely. After three to four years, if a company has survived, the probability of default decreases. Habakus agrees that the aging factor is a useful indicator because it shows bubbles of defaults come after large issuance years. But, Sam DeRosa-Farag, director of global leveraged finance strategy for CSFB, says a more accurate gauge is sector-specific events such as embedded risk and market share. "Issuers remain vulnerable to defaults in the case of an industry downturn regardless of the number of years that have passed since issuance," he says.
DeRosa-Farag also maintains that macroeconomic measurements are less relevant as predictors of credit quality as the economy has evolved from industrial manufacturing to service and technology-based products. "Historical correlations between economic conditions and spreads are now irrelevant as fundamental drivers are yielding better predictive qualities."
David Hamilton, analyst at Moody's, says the Annual Default Study further proves the relevancy of macro tools. Moody's RiskCalc model ascribes default probabilities to each industry. "This study implies correlation among industries to the macro economy," says Hamilton. CSFB says the recession in 1989-90 was largely caused by defaults, but Hamilton dismisses this argument, noting that macroeconomics often manifests itself first in default rates. "Often cash dependent, small and highly-leveraged companies default first and only then is there an obvious dip in GDP and a recession to follow."
Hamilton's new study lays out three distinct phases to recent credit history. The first was the Asian crisis, a macro problem that highlighted massive default rates. Phase two lasted through 2000 and consisted of many credit problems that built up in 1999-2000, where the impact is only now being seen. We are entering phase three, which centers around a broad-based economic slowdown coupled with individual credit problems.