“We could now be at a crossroads,” warns Deutsche Bank in its annual default study report. As the ‘artificial bond market’ is exposed and yield curves flatten on Fed rate hikes so carry risk-reward is reduced and default cycles have often been linked to the ebbing and flowing of the YC through time with a fairly long lead/lag. With HY defaults having spent 12 of the last 13 years below their long-term average (with the last 5 years the lowest in modern history), “a perfect default storm could be created for 2018 if the Fed raises rates in 2015.”
Defaults will stay unusually low so long as current artificial conditions continue. However, as Deutshe Bank explains, the benign default environment of the last few years may be about to change…
HY defaults (using Single-Bs as a proxy) have now spent 12 of the last 13 years below their long-term average. The average for the last 12 years is now 1.5% (0.9% excluding 2009) against an average of 4.9% since 1983 (1983-2002 average 6.9%). In recent years we’ve explained this phenomenally low default environment by discussing the increasingly artificial demand for fixed income which has allowed more borrowers to access capital markets at cheaper rates. Although growth is currently low relative to history, funding costs are even lower relative to the past.
While nominal and real yields are likely to stay low in a world of heavy central bank intervention and ultra loose policy, we make the argument that yield curve (YC) changes could still contribute towards the next default cycle. In the US we have found that whilst lower and lower real yields have structurally lowered the default rate over the last 30 years, a flattening of the YC has proceeded the last three default cycles by around 30 months. We have created a simple model that uses real yields and the YC (UST 10yr-Fed Funds) to predict defaults. While there are limitations, it has been a good guide to turning points in the cycle.
The model suggests that whilst defaults may start to lift off their lows over the next year due to a steady rise in US real yields since late 2011 and YC flattening between March 2011 and April 2013, the HY default rate should stay below the long-term average through 2016 and into 2017 due to a resteepening of the YC between April 2013 and March 2014 when Fed QE ‘infinity’ was still ongoing. As we move into the latter half of 2017 things become more interesting as the flattening seen in the US curve over the last 15 months starts to have a more significant impact on the model.In 30 months time (Q3 2017) the model suggest a US HY default rate of 4.1% (1985-2015 average 4.7%, average since 2003 4%).
We could now be at a crossroads. In Europe, we’ve seen dramatic recent flattening with the anticipation and introduction of QE. This could drag the US curve still flatter in the months and quarters to come (currently in the middle of its historic range). A perfect default storm could be created for 2018 if the Fed then compounds this by raising rates in 2015. This could create a much flatter YC over the next year if the long-end reacts more to rock bottom European yields, low inflation, a shortage of high quality assets or fears of a policy error from the Fed.
Why does the YC impact the default cycle? Steep YCs tend to create maximum carry conditions which usually lead to net loosening in lending standards and a weakening in issuance quality in capital markets as overconfidence builds. As the YC flattens, carry becomes slowly less compelling and while stretching for yield/risk might actually intensify first, eventually a flat yield curve leaves the weakest entities looking much more vulnerable than they did at the YC’s peak. Bank/investor risk tolerance reduces as the opportunity cost of carry trades increases and the risk-reward falls. This cycle does have a long lag but has been a repetitive feature of modern financial markets.
Perhaps the US Energy sector is the best example of this.
Without ZIRP, QE and a steep YC post-crisis, we probably wouldn’t have had the extended boom in HY Energy issuance. Our US credit strategists suggest how important the shale and natural gas revolution has been to the US economy over the last decade. Will its reversal signal wider economic problems ahead? As we noted previously, a third of all US HY Energy Single-Bs and CCCs are at risk of some form of debt restructuring with Oil prices around these levels for a few quarters.
Survival of the fittest
Even with a 40% cut to their capex budgets, an average producer is forecasting a 10% increase in production volume this year. This provides another reason to believe that the oil industry’s response to this point has been a necessary first step in the right direction but is unlikely to be the finish line in addressing this crisis.
Simple game theory helps us to understand their behavior: without a cartel and an ability to affect prices, each individual producer’s best survival strategy is to produce as many barrels of oil as possible given the limited financial resources to be able to cover its revenue shortfall to the largest extent.
As The Telegraph notes, Deutsche Bank’s warnings came as the International Monetary Fund said that the Fed’s first interest rate hike could trigger a “cascade of disruptive adjustment”.
