China Could Soon See Defaults on Certain Types of Public Bonds

Despite China’s 2014 Budget Law that stated local government financing vehicles (LGFVs) would no longer be recognized as public sector liabilities eligible for government support, no LGFV has defaulted on its publicly traded debt.

That situation is likely to soon change, according to Fitch Ratings in a new report, and could trigger a re-pricing of the market, analysts said. “However, widespread LGFV defaults remain a tail risk, given that the authorities continue to rely on local government investment—supported by LGFVs—to hit economic growth targets and have a broad spectrum of policy tools to limit default contagion.”

The Chinese government has tried to separate LGFVs from public-sector balance sheets as part of a larger effort to contain risks associated with the growth in municipal contingent liabilities, Fitch said. Debt ceilings and debt swaps have been used to convert LGFV obligations into explicit local government debt, but LGFV debt continues to rise strongly. Since the 2014 Budget Law, investors haven’t much changed their view of the likelihood of default for these bonds given the narrow spreads on LGFV securities, as “ … there remains a conflict between these stated central government policies and implicit support of LGFVs in practice at the local level,” Fitch said.

Fitch estimates approximately 5.4% of GDP in LGFV bonds issued domestically since 2015 remain outstanding, with pockets of excessive risk taking and debt hiding likely a part of the mix. Analysts predict that Chinese authorities might soon allow selected defaults on LGFVs that come under stress, particularly lower-tiered ones that consist of property with urban development.

“We would expect a re-pricing of LGFV bonds due to better risk discrimination by creditors and an accelerated replacement of the opaque LGFV mechanism with a genuine municipal bond and loan market,” analysts said. “It is also likely that market liquidity might dry up for some LGFVs, at least temporarily, which could cause problems for some issuers—particularly those that have issued debt with short maturities and are therefore exposed to refinancing risk. Access to foreign borrowing may also become more limited or expensive for some LGFVs.”

Still, the government is in a position to prevent systemic defaults, including the last-ditch use of a fiscal solution, Fitch said.

– Nicholas Stern, managing editor

Core Permian Basin Counties Mark Hot Spot for Improving Credit Quality

Oil and natural gas companies with operations mostly located in the core of the booming Permian Basin are poised to see their credit quality improve, while those operating at its fringes should see less of a bump, according to a new report from Moody’s Investors Service.

"E&P companies including Pioneer Natural Resources, Diamondback, Energen, RSP Permian and Parsley Energy all have high acreage concentrations in core counties with outsized Permian exposure, leaving them well positioned to prosper," said Moody's assistant vice president Paresh Chari.

Other firms with operations on the Permian fringes, such as Anadarko Petroleum, Chevron and Occidental Petroleum, would not likely see their credit quality improve just because of their development there, said Moody’s analysts. Legacy Reserves and EP Energy operate in the fringe areas but have moderate exposure, while Approach Resources mostly holds acreage in mainly fringe counties, leaving its credit quality vulnerable—weak well performance or unexpected declines in production being the primary cause, Moody’s said.

Moody’s sees recent acquisitions highlighting the Permian Basin’s booming counties for E&P activity. “Producers have spent almost $27 billion in the past year, targeting mainly the Martin, Glasscock, Howard and Reagan counties in the Midland Basin, and Reeves, Pecos and Ward counties in the Delaware Basin,” analysts said. “Rig counts also help demonstrate which counties are core to the Permian, with most rigs situated in the westward Delaware and eastward Midland basins. At mid-2017, oil production in those basins had risen to about 2.5 million bpd, with another 500,000 boe/d of growth expected by 2018.”

– Nicholas Stern, managing editor

Aircraft Lessors See Strong Outlook in Medium Term

Strong air travel growth, aircraft leasing, potentially rising lease yields and accommodative funding markets point to favorable industry conditions for aircraft leasing company credit profiles for the rest of the year.

Air traffic growth has stayed strong and, twinned with low oil prices over the last couple of years, has translated into a positive sector outlook for both airlines and aircraft leasing firms in recent years, according to a recent report by Fitch Ratings. Through July, revenue passenger kilometers were up 7.7% on the year, the highest rate since 2011 and above the average of 5.5%. Low oil prices have led aided airline profitability.

Aircraft lessors have seen low repossession activity and high utilization rates as more people choose to lease aircraft over ownership—about 40% of the global aircraft fleet was under an operating lease as of 2016, approximately double the rate 20 years prior, Fitch analysts said.

“Fitch believes that some of these favorable industry dynamics will moderate over the medium term,” the ratings agency said. “For example, air traffic growth is not likely to be sustainable at current levels and should decelerate. There are also some indications that aircraft demand may be beginning to slow, which could suggest that aircraft deliveries from the major producers could peak. That said, lower demand should not meaningfully affect aircraft lessors given already-high utilization rates.”

Aircraft lessor asset impairments have been low, reaching an average of 0.5% from 2012 to the second quarter of 2017, mostly through the resilience of the appraised value of some aircraft.

– Nicholas Stern, managing editor

Auto Industry on the Fast Track

The fast-changing automobile sector is set to exceed 100 million in annual sales in 2019, with China and India boosting worldwide sales growth this year and next, according to a new economic outlook on the industry from credit insurer Euler Hermes. The report assessed the auto industry in China, France, Germany, India, Italy, Japan, the U.K. and the United States, focusing on sales, electric cars, profitability and innovation.

The debt burden of manufacturers is lower than before the financial crisis, with the exception of those in the U.S. and Italy. Liquidity and capital expenditures remain stable, Euler Hermes said. Profitability is strong across the sector, with an average EBIT margin of 6% in 2016, up from its 5.5% level in 2015.

“The report identified three levers for innovation: R&D expenditure, patentable technology and external growth,” said Maxime Lemerle, head of sector research at Euler Hermes. “Traditional manufacturers in Germany, Japan and the U.S. lead the first two categories, while China and India exhibit aggressive growth.”

The number of electric vehicles could exceed 3 million worldwide in 2017. China, France, Germany, the U.K. and the U.S. are market leaders for battery-powered cars. China and the U.S. are expected to represent two-thirds of global electric vehicle sales by year end.

China is expected to be at the forefront of sales growth, with India in second place, which will offset declines in sales in the U.S. and U.K.

“New vehicle registrations are expected to grow globally 2.1% this year, as Europe is on the mend and manufacturers worldwide are making cars ‘cool’ again,” said Ludovic Subran, chief economist at Euler Hermes. “However, this is only half the growth of 2016, as new registrations in the U.S. and U.K. decline while used-car sales boom, and as China stopped tax breaks for car sales earlier this year.”

– Adam Fusco, associate editor

Toys ‘R’ Us Files for Chapter 11 Bankruptcy

Late yesterday, major retailer Toys ‘R’ Us announced that it and certain of its U.S. subsidiaries and its Canadian subsidiary filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the Eastern District of Virginia in Richmond. The filing excludes the company’s operations outside of the U.S. and Canada, which includes about 255 stores in Asia. The company’s approximately 1,600 Toys ‘R’ Us and Babies ‘R’ Us stores around the world, the majority of which are profitable, will continue to operate as usual, the company said in a press release.

“Today marks the dawn of a new era at Toys ‘R’ Us, where we expect that the financial constraints that have held us back will be addressed in a lasting and effective way,” said Dave Brandon, chairman and chief executive officer, in the release. “Together with our investors, our objective is to work with our debtholders and other creditors to restructure the $5 billion of long-term debt on our balance sheet, which will provide us with greater financial flexibility to invest in our business, continue to improve the customer experience in our physical stores and online, and strengthen our competitive position in an increasingly challenging and rapidly changing retail marketplace worldwide.”

Toys ‘R’ Us has struggled amid the rise of discounters such as Wal-Mart and Target, and especially Amazon.com, the Wall Street Journal reported.  Most Toys ‘R’ Us stores are expected to be open during the holidays, and the company will use $3 billion in bankruptcy financing to continue to finance its operations, the Journal said. More than 20 retailers, including RadioShack and Payless Shoe Source, have filed for bankruptcy this year.

With assets of $6.9 billion, this marks the second-largest retail bankruptcy after Kmart, Reuters reported. Toys ‘R’ Us is the second-largest toy seller in the United States behind Amazon, the news agency added.

– Adam Fusco, associate editor

Asia-Pacific Economies to Gain from Global Demand, Structural Reforms

Global demand has helped steady Asia-Pacific’s economies that are so reliant on trade, but sovereign profiles will remain strongest where the export surge mixes with structural reforms and investments in infrastructure, according to a new Moody’s Investors Service report.

China and Japan have been contributing to the global uptick in trade and supporting regional demand, Moody’s analysts said. Moody’s has raised its GDP forecasts for Asia-Pacific economies, and should external demand and robust domestic conditions form to sustain business investment, the ratings agency expects the medium-term growth outlook will remain positive.

“The acceleration in growth in Hong Kong (Aa2 stable) and Malaysia (A3 stable) looks to be more broad-based than in other trade-dependent economies, reflecting in part the strength of public infrastructure spending,” Moody’s said. “In the event that solid external demand persists and ongoing government infrastructure spending supports a further wave of investment by private businesses, that could mean that growth there slows less in 2018 than we currently expect.”

Countries like Thailand that don’t benefit as much from accelerating global demand may have to rely more on additional fiscal stimulus to support their economies, analysts said. “Trends in gross fixed capital formation have differed markedly among the region's trade-dependent economies, suggesting that some businesses have started to invest in new or replacement equipment and facilities, while others are still using existing idle capacity to meet increased demand.”

The positive effects on the economy following India (Baa3 positive) and Indonesia’s (Baa3 positive) efforts to attract more foreign direct investment, as well as steps they’re taking to improve business conditions, will be boosted in a stronger global macroeconomic environment. “Similarly, the global up-cycle will amplify improvements in business operating conditions in Vietnam (B1 positive) that have already attracted investment and helped production move up the manufacturing value chain,” Moody’s said.

– Nicholas Stern, managing editor

Interest Payment Due Date Risks Rise in U.S. High-Yield Default Rate

Today marks a deadline for several U.S. high-yield companies to make interest payments, otherwise the default rate would move above the current 1.8% mark, according to Fitch Ratings.

The companies include two large retailers. Claire’s Stores and Nine West Holdings are on Fitch’s Bonds of Concern list, which means a high probability of default within the next year. Claire’s CEO indicated during a recent earnings call that the payment would be made. Same-store sales trends for the company have been positive for the first half of the year, but declining U.S. mall traffic and rough macroeconomic conditions in Europe weigh on the top line. Liquidity remains tight but adequate to fund this year’s holiday season, Fitch said.

The interest payment for exploration and production company EXCO Resources is more in doubt. The termination of its asset sale resulted in its bid price declining about 35 points in recent weeks, the ratings agency said.

“The September sector trailing 12-month [TTM] high-yield rate is at 2.1%, with less than $1 billion of defaults,” said Eric Rosenthal, Fitch’s senior director of leveraged finance.

In August, for the second consecutive month, the TTM U.S. high-yield default rate remained below 2%. Only $1 billion in high-yield bond defaults were registered during that period. Ongoing stress in the retail sector as well as a pending filing from iHeartCommunications may result in the rate rising to just below 3% by the end of the year. After oil-drilling contractor Seadrill filed for bankruptcy on Sept. 12, the Yankee index’s default rate rose to 3.3%. Fitch expects the Yankee default rate to end the year near 4%.

– Adam Fusco, associate editor

Reinsurers Exposed to Hurricanes Harvey and Irma to See Capital Strains

Re-insurers with disproportionate combined exposures to hurricanes Irma and Harvey could wind up seeing losses at levels that could strain capital and pressure their credit ratings, according to a new report by Fitch Ratings.

AIR Worldwide currently estimates insured losses from Hurricane Irma between $20 billion and $40 billion in Florida, with an extra $5 billion to $15 billion in the Caribbean, the ratings agency said. Insured losses from Hurricane Harvey range from $10 billion to as high as $30 billion, excluding losses to the National Flood Insurance Program.

“Fitch believes if losses ultimately reach this level, or higher, there may be select (re)insurers with concentrations across each locale that, added together, could adversely affect capital,” analysts said. “However, we believe such cases will not become evident until (re)insurers provide their own specific loss experience.”

Also, Fitch said its ratings coverage will not include small Florida specialist insurers with approximately 60% market share in Florida homeowners’ insurance, which will yield most losses to reinsurers. “Hurricane Irma will be the first notable test of these groups' underwriting policies, claims-handling capabilities, reinsurance programs, capital strength and overall risk management,” the ratings agency said.

– Nicholas Stern, managing editor

Global Speculative-Grade Default Rate Falls to Lowest Level in Nearly Two Years

In August, the global speculative-grade default rate fell below 3% for the first time since October 2015, according to a new report from Moody’s Investors Service. The rate fell 0.2% from its 3.1% level in July. The ratings agency anticipates that the rate will reach 2.3% in August 2018, down from a high of 4.8% two years previously, when commodity sectors drove the default rate to its highest level in seven years.

“This benign forecast is a function of a relatively low level of high-yield spread and stability in commodity prices,” said Moody’s Vice President and Credit Officer Sharon Ou.

Two speculative-grade companies defaulted last month: a U.S. retailer that completed a distressed exchange and a Singapore-based semiconductor assembly and test services provider that failed to make coupon payments, Moody’s said. The most vulnerable industries include media advertising, printing and publishing, durable consumer goods and retail.

For the United States alone, the speculative-grade default rate declined to 3.4% in August from 3.6% in July. In Europe, the rate fell to 2.6% from 2.8%.

– Adam Fusco, associate editor

Small-Business Optimism Heads for Record Levels

A surge in capital spending and high sales expectations have caused a streak of historically high performances dating back to November to continue in the Index of Small Business Optimism from the National Federation of Independent Business (NFIB). The percentage of small-business owners who plan to make capital expenditures in the near term is at its highest level since 2006.

“This is a sign of economic health that we’ve been expecting based on the soaring optimism that began last year,” said NFIB President and CEO Juanita Duggan. “Higher optimism resulted first in higher employment activity, and now we’re seeing more small-business owners making capital investments. Consumer demand is very strong, and the regulatory relief has been dramatic. Small-business owners still expect progress on tax reform and health care, and they will be watching closely.”

The index rose 0.1 points to 105.3. Five of the components of the index rose while five declined. Those planning capital outlays were highest among professional service firms (46%), followed by manufacturing (38%).

“Small firms are now making long-term investments in new machines, equipment, facilities, and technology,” said NFIB Chief Economist Bill Dunkelberg. “That’s a real sign of strength, and it will be interesting to see if the August result becomes a trend.”

Those expecting better sales in August increased by 5% to a net 27%, which matches the number of owners who believe factors are favorable for expansion.

“Consumer demand is driving optimism, and optimism is driving business activity,” Duggan said.

– Adam Fusco, associate editor

Energy Default Risk Sees Little Change after Harvey

While Hurricane Irma continues to devastate Florida, the economic costs of Hurricane Harvey, beyond the human toll, are starting to be evaluated for the states of Texas and Louisiana. The storm is likely to have little impact on the default risk of the North American energy sector, according to Moody’s Analytics’ Expected Default Frequency (EDF) probability of default metrics. The sector’s average one-year EDF fell by 0.06% from its level prior to Harvey’s landfall in August, indicating a lower level of default risk. Most energy subsectors participated in the decline, Moody’s said.

The hurricane caused an immediate drop of over three million barrels a day in refinery output, with smaller declines in the demand for petroleum products and crude oil production. The small change in energy sector risk goes hand in hand with Moody’s Analytics’ evaluation that the region’s economy should recover quickly and that the hurricane will have only a small effect on the national economy, though southeastern Texas and Louisiana house 21% of the United States’ refining capacity. Moody’s estimates that 45% of the refining capacity shut down by Harvey is already back on line.

Some refineries, however, suffered more severe damage than others and will be slower in restoring operations. Moody’s estimates that refinery profit margins will rise in the near term as a result, since the reduction in capacity gives leeway for the remaining companies to increase prices. Moody’s further estimates that the price of energy will be higher in the coming months because of a minimal decrease of demand for petroleum products and the shutdown, though temporary, of several offshore and shale oil and gas rigs. The higher energy prices will make it economical to resume drilling and production, with strong demand for rigs, the ratings agency said.

– Adam Fusco, associate editor

Global Economy Gathers Momentum

The global economy expanded at its fastest pace in nearly a year and a half in August, with improvement in both the manufacturing and service sectors and business optimism moving higher. The August J.P. Morgan Global All-Industry Output Index registered 53.9, up from 53.6 in July. This marks the 59th month in a row that the index posted above the 50 neutral mark.

“The August PMI [Purchasing Managers’ Index] signaled a broad and accelerated expansion of global economic output,” said David Hensley, director of global economic coordination at J.P. Morgan. “Overall growth was the quickest since April 2015, underpinned by expansions across the six main categories of manufacturing and services covered by the survey. With new order inflows strengthening, backlogs rising and jobs growth accelerating, the economy looks set to perform well in the coming months.”

Developed nations outperformed emerging markets. The euro area saw a solid gain in economic output, with faster growth in Germany and Ireland. Strong growth in manufacturing was offset by a more tepid increase in the service sector. Output growth in the United States was at its steepest since January. Some acceleration of growth was noted in Japan, while growth slowed to a 10-month low in Australia. Among the emerging nations, economic output accelerated in China and Russia but fell in India and Brazil.

An increase in the backlog of work and further job creation resulted from new business rising at its quickest in nearly three years, while the growth rate of employee numbers reached a 77-month record. Staffing levels rose in the U.S., eurozone, Japan, the U.K., India, Australia and Russia.

– Adam Fusco, associate editor

Corporate Debt Rises, Along with Lower Quality Bonds

Two decades ago, the size of the corporate bond market was approximately $3 trillion, with 20% of the market issued in the lowest level (Baa and BBB) of the investment-grade rating scale.

Now the corporate bond market is estimated at $5 trillion, with 49% of the market issued in the Baa and BBB categories, according to a recent report by Seeking Alpha. While the amount of debt has increased, low interest rates have boosted leverage and credit quality has declined. “The potential ramifications of this shift are enormous,” the article stated. “We are in the very late stages of the business cycle, where you want to own quality. Corporate spreads are tight to treasuries, offering nominal premiums for associated risks.”

Meanwhile, traders have been hedging their corporate bond investments by piling money into derivatives, as volumes in these instruments have increased 110% in the week ended Aug. 11, compared to the same time a year prior, a Bloomberg report noted. For most of 2017, derivatives activity was relatively muted. As of late, investors in corporate debt appear to want to mitigate the risks of potential hits to the broader economy, like hurricanes or geopolitical dust-ups.

– Nicholas Stern, managing editor

Kamakura: Corporate Credit Quality Stays Consistent in August

With just a slight increase from the month before, the Kamakura Corporation troubled company index ended August at 7.84%, reflecting the percentage of companies that have a default probability of more than 1%. An increase in the index indicates a reduction in credit quality while a decrease indicates an improvement in credit quality.

“Credit metrics continue to be stable and benign during August, with a decline in the number of observed defaults to a multimonth low,” said Martin Zorn, president and chief operating officer for Kamakura Corporation. “Overall government statistics show reductions in household debt burden, although U.S. credit card debt is near the peak levels reached in 2008. We continue to believe the biggest risk is the leveraged loan sector, once interest rates begin to rise.”

Among the 10 firms rated at most risk, seven were from the United States, two from Great Britain and one from Singapore. Two defaults occurred in the coverage group, the most prominent being Air Berlin. The riskiest rated firm is Ascena Retail Group, with a Kamakura default probability of 26.9%. For August, the percentage of companies with default probabilities between 1% and 5% was 6.5%; the percentage of those with default probabilities between 5% and 10% was .92%.

The Kamakura troubled company index measures the percentage of firms that have an annualized one-month default risk over 1% among a group of 39,000 public firms in 68 countries. Kamakura uses a large historical database with more than 2.2 million observations to produce a forward-looking statistical estimate of default risk 10 years into the future, with the troubled company index focusing on the short term.

– Adam Fusco, associate editor

Global Oilfield Services and Drilling Sector Set for Stable Period

Prospects for the global oilfield services and drilling sector (OFS) have turned the corner and now appear to have stabilized after a stretch of severe demand and price erosion.

"The stable outlook for the global OFS sector reflects our view that the worst is now behind us and we are in the early stages of a cyclical recovery," said Moody's analyst Sajjad Alam. "After a weak 2016, we expect industry earnings to grow 6% to 8% in 2017 and more substantially next year, given improved prospects for commodity prices and higher upstream spending."

In North America, exploration and production companies are expected to spend 25% to 30% more this year, while overall global upstream spending should grow by mid-single-digit percentages, leading to rising revenues, Alam said. But substantial cash flow growth won’t be seen until 2018, as global oil markets continue to slowly rebalance and OFS pricing only modestly improves, Moody’s said.

Also, some markets will continue to suffer further revenue and EBITDA declines, analysts said. “Many companies have to cover significant reactivation costs, rising labor costs and increasing working capital demands during the early phases of recovery,” Alam said. Demand is expected to grow mostly in U.S. and Canadian land markets, where activity contracted most significantly during the downturn. “Completion-related services will see the highest price appreciation, though cash flows will still grow only modestly this year.”

Drilling efficiency and well productivity improvements are expected to slow rig additions this year, as the U.S. rig count will likely settle around 1,000 rigs, Moody’s said. Rig counts in international land markets are also expected to slow through mid-2018.

For offshore projects, near-term prospects remain challenged as major deepwater/ultradeepwater development is unlikely to be green-lighted until oil prices rise above $60 per barrel, analysts said. “Revenues and backlogs for offshore drillers, equipment manufacturers and logistics companies will continue to decline as customers offer low-margin contracts, or avoid contracts altogether, while overcapacity in the offshore segment takes several years yet to clear.”

– Nicholas Stern, managing editor

Chinese Overseas Investment Guidelines Could Hamper International Deals

New Chinese guidelines on overseas investment are likely to concentrate risks and increase costs and the complexity of regulations for investment companies in the country.

Risks will grow because the new rules, issued by the State Council this month, will narrow the range of industries in which investment companies can invest overseas, according to a new report from Fitch Ratings. The longer and more complex process for approving deals could negatively impact profitability as well, though they could serve to moderate investment companies’ recent rapid overseas expansion.

The guidelines reflect the government’s worries about the pressure that overseas investment could put on the currency and the aggressive bidding on overseas assets by Chinese investment companies and insurance companies, Fitch analysts said. The guidelines are also designed to align overseas investment with the priorities of the “One Belt, One Road” initiative.

“ICs [investment companies] will face much greater regulatory scrutiny when investing in several overseas sectors, including real estate, hotels, entertainment and sports clubs, which investors had been expecting to benefit from demographic changes and economic rebalancing,” the report stated. “While ICs have invested in these sectors overseas, they generally have not done so in China, and the changes will therefore reduce diversification of ICs' investment portfolios in terms of sector, and weaken ICs' overall appetite for international investment.”

Analysts also believe the guidelines will make it more difficult for investment companies to raise foreign-currency funding overseas, as well as make it more time-consuming to get approval for any international mergers and acquisitions.

– Nicholas Stern, managing editor