Defaults to rise as economyslows

The number of U.S. companies that slipped from good to junk credit ratings jumped to 33 this year, the most since 2003.

Those downgraded to junk by Moody's Investors Service include Jones Apparel Group Inc., the Bristol, Pa., retailer of the Nine West, Anne Klein and Gloria Vanderbilt brands. Together, the 33 companies have 52 billion in debt that was cut from investment-grade to a junk-bond rating.

Moody's, a major credit-rating service, also is predicting that U.S. companies will default on 4.7 percent of their bonds in 2008 as the economy slows, compared with 1 percent this year.

In another sign of trouble in the debt market, data from Merrill Lynch & Co. Inc. show that corporate bonds returned just 3.08 percent in 2007. That's less than the rate of inflation, and indicates that subprime-related losses drove buyers to the relative safety of government debt. U.S. Treasuries returned 7.79 percent, according to Merrill Lynch.

"When the economy slows down, there's going to be more defaults and more companies going into junk land," said Mirko Mikelic, a senior bond-fund manager at Fifth Third Asset Management in Grand Rapids, Mich.

Overall, rating downgrades are accelerating. Moody's reduced ratings on 389 corporate issues in the current quarter, compared with 150 upgrades, according to data compiled by Bloomberg. The gap between downgrades and upgrades was the biggest since the first quarter of 2003.

Moody's defines junk, or noninvestment-grade, bonds as those rated below "Baa3." That level is roughly in the middle of the company's 21 credit ratings.

Meanwhile, Standard & Poor's said last week that it was considering a cut in the rating of 447 companies, led by firms in the automotive industry.

Companies that already have lost their investment-grade rankings, known as fallen angels, included Boston Scientific Corp. of Natick, Mass., the second-largest maker of heart devices; Belo Corp., the owner of the Dallas Morning News and 20 television stations; and Nuveen Investments Inc. of Chicago, which manages closed-end mutual funds.

"With the economic slowdown, we will have a year of more ratings downgrades than upgrades, steeper default rates as well as more fallen angels," said John Lonski, the chief economist at Moody's, which is based in New York. The chances of a recession are almost 50 percent, he said.

Jones Apparel was cut to speculative-grade this quarter after the company sold its Barneys New York Inc. for $945 million to an affiliate of Dubai's Istithmar PJSC. Moody's lowered the ranking to "Ba1," and S&P cited a "weaker" risk profile for cutting Jones's $750 million in debt to "BB+."

"We continue to have discussions with the rating agencies, focusing on our road map to return to investment grade," John McClain, Jones's chief financial officer, told analysts on an Oct. 31 conference call.

A lower credit rating typically means a company must pay a higher interest rate for its bonds. But the downgrade for Jones Apparel is having a "minimal impact" on financing costs, McClain said.

In the overall credit market, investors on average demand an extra 2.84 percentage points in the interest rate to own corporate bonds rather than Treasuries, according to index data compiled by Merrill Lynch. That has doubled since June - before losses from securities backed by subprime mortgages contaminated credit markets.

The last time so many companies were cut to junk rating was after WorldCom Inc. in Jackson, Miss., and Adelphia Communications Corp., then based in Coudersport, Pa., filed for bankruptcy in 2002.

The extra interest may be a sign that bondholders already account for the risk of more failures, said Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, N.M.

"Investors are already anticipating the fact that there are going to be a lot more defaults, so I don't think spreads are going to widen out further the same way they did from July to here," Brady said.

Defaults probably will remain below the 5 percent historical average, so bondholders will make money even if more borrowers miss payments in 2008, said Kenneth Hackel, head of fixed-income strategy at RBS Greenwich Capital Markets in Greenwich, Conn.