Column: A double-digit default rate “hurricane”


A trader works on the floor of the New York Stock Exchange (NYSE) in Manhattan, New York, U.S., May 18, 2022. REUTERS/Andrew Kelly

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LONDON, June 8 (Reuters) – If there is indeed an economic hurricane coming, then someone should shake up the junk bond market.

JPMorgan boss Jamie Dimon publicly expressed concern last week that, while the sun was still shining in the financial world, “a hurricane is right out there on the road coming our way.” Read more

An economic hurricane can of course mean a lot of things to a lot of people – rising inflation, borrowing rates and unemployment come to most people’s minds. But for corporates and bond investors, soaring default rates and bankruptcies are defining a super storm.

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Like struggling stock markets, the prospect of central bank interest rate hikes to rein in decades-high inflation means U.S. corporate bonds have already had a torrid start to the year – with investment indices and exchange-traded funds falling 10-15% while borrowing rates jumped again after two years of near-record lows.

And yet the yield premium on “junk bonds,” the riskiest below-investment-grade corporate bonds, over U.S. Treasuries remains below the average spreads of the past 20 years – where they have been for much of the past decade if you put aside a brief three-month pandemic flare. The American junk would have provided an average total return of 5% per year over the past 10 years.

But if a climate of low inflation and low interest rates accompanied by slow growth without recession explains much of this serenity, then the fear that the coming decade will disrupt all these assumptions should irritate most investors.

Despite Dimon’s storm warning, his economists at JPMorgan do not expect a US recession next year. Those who remain in the minority, though figures like Goldman Sachs chief operating officer David Waldron also spoke last week about the challenges of an unprecedented confluence of shocks. Read more

But Deutsche Bank is one of the few to officially forecast two consecutive quarters of contraction for the US economy in the second half of 2023 and its view of the impact on corporate failures speaks of strong winds that could accompany that.

In an annual review of corporate credit outlook titled “The End of the Ultra-Low Default World?”, strategists Jim Reid and Karthik Nagalingam believe that next year’s recession will see the rate of unwanted defaults in states rise from an all-time low of around 1% now to 5% by the end of 2023 and double again to 10.3% in 2024.

This double-digit default rate across the high-yield bond spectrum would be the highest since the crash of 2008 and would reflect the double-digit default rate spikes that followed previous recessions in 2001/2002 and early 1990s before that.

Deutsche Bank chart of historical default rates
High Yield Bond Spreads in the United States and Europe


In this scenario, they expect aggregate junk spreads on Treasuries to double from current levels to 850 basis points by the end of next year.

The breakdown into related sections is more revealing. While default rates for companies with BB credit ratings just below investment grade are expected to peak at 2%, simple B ratings could reach 11% and defaults for highly speculative CCC-rated companies could reach 45. %.

And since BB names have a much higher weighting in European junk bond indices, default rates are expected to peak at 6.6% overall.

Deutsche strategists conclude that markets are simply not rated for this scenario based on historical comparisons. Assuming that 40% of initial investments could be recovered after a default, current high yield spreads would not compensate for the defaults seen in the six discrete default cycles since the late 1980s.

Their view hinges on what they call a “standoff” between rising real yields and term premia and governments’ desire to prevent the “super debt cycle” from being exposed. But they believe that this will be slower to materialize than before in the face of persistent inflation problems and will only be selective in certain areas such as the periphery of the euro zone.

“The fact that we have this tension going both ways, however, means that the era of two decades of low inflation, steadily declining term premia and real yields, long economic cycles, maximum profit margins, intervention central bank guarantees and immediates, all of which occur together, is likely over,” Reid writes.

And just as Deutsche’s view of defaults hinges on recession and lingering inflation forecasts that are still minority opinions, it’s also true that many investors’ more relaxed attitude toward junk bonds is shaped by their more benign assumption of context.

In its five-year “Secular Outlook” on global investments released this week, Pictet Asset Management dismissed talk of a long-term structural shift in the global economy towards a new regime of high inflation and stagnant growth akin to 1970s.

Seeing economic growth and inflation return to the averages of the last 10 to 15 years, they believe that the current macroeconomic volatility is temporary, linked to the pandemic and supply shocks, and that the megatrends of gluts of savings and low productivity growth have not changed enough to raise the real. pays off sustainably.

“Until real interest rates are much higher, I find it difficult to see a structural increase in default rates,” said Luca Paolini, chief strategist at Pictet AM, adding that a “zombification “Additional businesses surviving on cheap credit was a more likely problem.

A strong breeze for some then rather than a hurricane.

Whether long-term investment forecasts outperform their weather counterparts remains to be seen.

High Yield, Investment Grade U.S. ETFs

The author is Finance and Markets Editor at Reuters News. All opinions expressed here are his own.

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by Mike Dolan, Twitter: @reutersMikeD Editing by Mark Potter

Our standards: The Thomson Reuters Trust Principles.

The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and non-partisanship by principles of trust.

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