By Patricia Kuo and Paul Gordon
April 3 (Bloomberg) -- Investors are pricing in defaults on corporate bonds twice as high as projected by rating companies, said Deven Sharma, Standard & Poor's president.
``The markets are pricing in a default rate of 9 or 10 percent for high-yield corporate debt, which is a lot higher than we're forecasting,'' Sharma said in an interview with Bloomberg Television. ``There is a recession and the recovery will be somewhat slower than we anticipated.''
The credit assessor said on March 31 the default rate for non-investment grade U.S. corporate bonds may rise to as much as 5.7 percent by February next year, as companies are hurt by rising funding costs and a slowing economy. The rate was 1.09 percent in January.
S&P, Moody's Investors Service and Fitch Ratings are struggling to shore up confidence in their credit rating systems for structured securities, after debt and equity investors suffered trillions of dollars in losses from the collapse of the U.S. market for subprime mortgages. The rating companies have been criticized for granting excessively high ratings to securities tied to home loans and reacting too slowly when defaults reached record rates.
``Rating agencies have been a bit more pro-active recently, but I don't see investor confidence returning in full just yet,'' said Sydney-basedBillBovingdon, head of Australia fixed income at Aberdeen Asset Management Plc, which manages $100 billion of credit worldwide. ``There is still some rebuilding to do for them to shore up their role in the investment landscape.''
Record Downgrade Risks
The number of companies at risk of credit-rating downgrades rose to a record 703 in March amid a slowdown in housing and consumer spending that pushed the economy closer to recession, S&P said on April 1. The number of potential downgrades is 90 more than reported a year ago and 68 more than the 2007 average.
The spread, or extra yield, on corporate junk bonds in the U.S. reached a five-year high on March 17, according to a Merrill Lynch & Co. index that tracks 1,303 securities.
Politicians and regulators are seeking new rules to make rating companies adjust their income structures to better prevent conflict of interests. At stake is a business model in which borrowers rather than investors pay for credit ratings.
S&P has no immediate plan to alter the revenue structure, although it may make changes if markets decide a different model makes more sense, Sharma said in the interview, aired today.
Conflicts of Interest
S&P had a model focused on investors 35 years ago, ``but then we had the questions about investors having an influence on us, that's why in any model, there will always be a perception of conflicts,'' Sharma said.
Regulators including Michel Prada, France's chief securities official and chairman of the International Organization of Securities Commissions' Technical Committee, have rebuked ratings companies for their role in securities responsible for at least $232 billion of writedowns and losses caused by the subprime slump.
The Madrid-based organization is the main forum for securities regulators in more than 100 countries.
European Central Bank President Jean-Claude Trichet and U.S. Senate Banking Committee Chairman Christopher Dodd last year flagged potential conflicts of interest from the rating companies' business model.
`More Transparent'
``The rating agencies need to demonstrate there is no conflict of interest in their business models and they need to be a bit more transparent on how they rate the credits, and they also need to be as much focused on investors as on borrowers,'' said Bovingdon at Aberdeen, which relies more on its internal credit analysis than on rating companies.
Moody's is the least accurate assessor of the risks of subprime-mortgage securities among the three largest credit- ratings companies, while Fitch is the best, according to UBS AG.
Moody's assigns Caa2 or lower ratings to just 12 percent of the 292 bonds underlying benchmark Markit ABX indexes that UBS analysts expect to default. Both Fitch and Standard & Poor's tag 57 percent of the bonds with equivalent rankings, according to a report from the New York-based analysts yesterday. A rating of Caa2 or CCC is eight levels below investment grade.
Shares of McGraw-Hill Cos., the owner of S&P, fell 11 percent this year. Moody's Corp., whose largest shareholder is Warren Buffett's Berkshire Hathaway Inc., rose 5 percent.
Lessons
S&P is ``learning lessons'' from the current crisis, whose depth and severity is larger than expected, New York-based Sharma said.
``There is a fundamental change of behavior by consumers,'' he said. ``For many years, going back to the Great Depression, consumers always first paid their mortgage and if they default, they would default on their credit cards. For the first time, in 2005, we started to see the line being crossed, where consumers are willing to walk away from their mortgages.''
New home foreclosures in the U.S. rose to a record high in the fourth quarter as borrowers with adjustable-rate loans walked away from properties before payments increased, the Mortgage Bankers Association said in a March 6 report. Late payments, or delinquencies, were the highest in 23 years, the group said.
To contact the reporter for this story: Patricia Kuo in Hong Kong atpkuo2@bloomberg.net
