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"The Default Cycle Is Now Unavoidable": How The 'Junk' Cancer Spread To The Entire High Yield Space

Tyler Durden's picture




 

One week ago we presented a must read report by Ellington Management which explained that the credit cycle is now turning.

As Ellington pointed out, "We believe that we are now at the end of the "over-investment" phase of the corporate credit cycle in the US that has been playing out since the depths of the GFC. This view is supported by a number of telltale signs of a reversal in the credit cycle:

  • Worsening Fundamentals - Declining corporate pro ts, record levels of corporate leverage, and an elevated high yield share of total corporate debt issuance
  • Defaults/Downgrades - Credit rating downgrades at a pace not seen since 2009
  • Falling Asset Prices - Price deterioration in the lowest quality loans and the most junior CLO tranches
  • Tightening Lending Standards - Weak investor appetite for new distressed debt issues, declines in CLO and CCC HY bond issuance, and tightening in domestic bank lending standards

Today, the Deutsche Bank credit strategy team led by Oleg Melentyev, in its "Year-Ahead Outlook 2016" report proves beyond a doubt that not only has the credit cycle turned, but that the default cycle is at hand, initially for energy names ("a default cycle in commodity-related areas at this point is unavoidable, and the only real question here is whether it stays contained to those areas or extends itself to other sectors") and soon for most other sectors.

Here is Melentyev's unpleasant message for Yellen, who is now about to hike rates and launch a tightening cycle at precisely the time when should be easing further to take away from the pain that will be unleashed by an inevitable junk bond supernova.

The current credit cycle can be described as mature: it’s old enough, at almost five years, and extended itself far enough (55% debt growth) to be falling right in line with three cycles that came before it in the past 30 years. A widely publicized McKinsey1 study earlier this year estimated a total of new debt created since 2007 at $50trln, half of which came from EM and two-thirds from nonfinancial corporate issuers in DM and EM. Our research suggests that global debt growth rates have remained steady as a percentage of global GDP, at 64%.

 

A large portion of this funding went towards commodity-related projects, particularly in EM. Our own credit indexes also tell us the extent of exposure to commodities, which is roughly 40% in EM world, and close to 25% in DM. This debt was raised at a time when consensus firmly believed in the commodity super-cycle theory, which at this point we know was wrong. This leads us to believe that a default cycle in commodity-related areas at this point is unavoidable, and the only real question here is whether it stays contained to those areas or extends itself to other sectors.

 

Evidence we are looking at suggests there is a meaningful probability of seeing early stages of the next default cycle developing in non-commodity sectors as well. We have previously presented a set of indicators in the Evolution of the Default Cycle report in early October, suggesting that recent equity volatility spikes and a widening in highest-quality corporate spreads are potential triggers for tightening credit conditions. We further followed up in recent weeks by showing rare trends emerging in HY underperforming both equities and IG as well as CCCs underperforming BBs, both the types of market behavior usually seen around turning points in the cycle.

Behold the metastasis of the junk bond cancer:

Figure 1 below shows how distress (bonds trading over 1,000bps) has been spreading across the HY space. From its starting point in energy a year ago, it has now reached other commodity-sensitive areas such as transportation, materials, capital goods, and commercial services. But it did not stop here and is also visible in places like retail, gaming, media, consumer staples, and technology – all areas that were widely expected to be insulated from low oil prices, if not even benefitting form them.

In other words, what was until a year ago a purely "energy" phenomenon is now an "everything" phenomenon, despite promises by every prominent economist that plunging energy prices are great news for the economy. As always happens, the economists were dead wrong once again.

It gets worse:

There is another interesting aspect of the distressed environment – overall distress ratio today, at 19% of face value of overall US HY – is only modestly higher than its level at the peak of Oct 2011 selloff (17%), and is comfortably inside of EU HY distress of 35% in early 2012. So one could argue that this level in and of itself is not meaningful, given that it misfired at least twice in recent years. We do not fully agree with such an argument, as it ignores the fact that 2011 and 2012 were still in early stages of the credit cycle, but we would give it 1/2 a credit for trying.

 

When we change the question and ask what percent of names are in deep distress today, defined here somewhat arbitrarily as 2,000bps (dollar prices around 50pts), the answer we get is 7.1%. This level is materially higher that 2% in US HY back in Oct 2011 or 6% in EU HY back in Jan 2012.

DB is very concerned at the implications of this:

Think about the significance of this number. While some names flirt with modest levels of distress from time to time throughout the normal course of events during the expansionary phase of a cycle, many of them stage comebacks and remain current on their debt obligations. In other words, not all distressed names today will default tomorrow. To witness, the total value of unique cusips in our DM HY index that ever touched on 1,000bps since 2009 through 2014 is $600bn. The actual grand total of defaults during this time is $135bn.

 

For that same timeframe, $130bn of unique bonds touched on a 2,000bp level. It’s also interesting to note that peak in deep-distress ratio in Figure 2 reflects peaks in actual default rates closely (18% deep distress par vs 20% par default rate in 2002 cycle, for example). It appears that few names ever come back from the deeply distressed levels, and their prevalence in today’s environment has to be taken seriously by credit investors. Ex-energy this metric currently stands at 3.1% of index face value.

Does the credit cycle precede the business cycle or vice versa? The answer: yes.

A generic push-back we hear on this view from time to time is this: how can you be expecting tighter credit conditions and higher default pressures when US economy is doing so well? Our answer is that one does not necessarily contradict the other. We strongly believe that credit cycle leads the business cycle, and as such it is not a pre-requisite to first see a slowing economy and only then to expect tightening in credit. In fact this turn of events would be quite unusual.

 

The simplest proof we can provide in support of this is shown in Figure 3 below, where as some of our readers would recognize, we are repeating charts from the cycle evolution piece, showing zoomed-in versions of turns in the past three credit cycles. The grayed-out areas are marking the last 12 months before such turns, and here were are also adding a snapshot of health of the US economy, on average, during those last 12 months. Numbers speak for themselves, but both real GDP growth and non-farm payrolls remain solid and stable during these short time windows.

 

This is not to suggest that macro environment is irrelevant; it clearly is. But it is important to remember that a stable and solid economy alone is not sufficient to suggest that a turn in credit conditions is impossible.

Deutsche Bank's conclusion:

Overall, all this evidence continues to suggest that default pressures are likely to start accumulating during 2016 even outside of commodity sectors. We forecast ex-commodity default rate to reach 3.5% among US HY issuers, up from the current level of 1.9%. Combined with commodity producers, we are looking at 5.75% overall US HY default rate.

None of which, of course, assumes short-term rates around 1% or higher: in that case the default rate will spike proportionately as the issuance window for even the most creditworthy issuers is practically closed.

Finally, where this imminent default cycle will have unexpected downstream consequences is on the balance sheets of the debt buyers themselves: moments ago SMRA reported that according to its Money Manager Survey, portfolio managers are holding the largest percentage of corporate bonds in history, with allocations rising to 35.8%, surpassing the previous record of 35.7%, seen last week, and 35.6% 2 weeks ago.

In other words, everyone is long and strong just as the bottom is on the verge of falling out of the market.

 

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Wed, 12/09/2015 - 14:39 | 6900474 Squid Viscous
Squid Viscous's picture

bring it on! except not until after Xmas I still have to get my kid GI Joe with the Kung Fu Grip

Wed, 12/09/2015 - 14:41 | 6900486 Hippocratic Oaf
Hippocratic Oaf's picture

First thing to collapse is junk bonds. Spreads are very wide right now and will get worse, dragging down prices. Then the DOW will follow, margin calls, then all bonds will get crushed due to sell off to address margin calls.

Just. Like. '08-'09

Get yo popcorn ready bitchez. We can't print our way outta this.

Wed, 12/09/2015 - 15:17 | 6900622 NoDebt
NoDebt's picture

You guys are so pessimistic.  I have the strongest assurances that this is well contained to the energy sector and won't spread beyond that.  It'll be fine.  You'll see.

 

Wed, 12/09/2015 - 16:14 | 6900857 Joe Sichs Pach
Joe Sichs Pach's picture

Energy and ISIS - contained.

Much like housing in '06-'07

Thu, 12/10/2015 - 00:22 | 6902879 Antifaschistische
Antifaschistische's picture

but, if we just repeated 0809, then...the lesson is that everything work out and things get better and all prices will recover very nicely.  It's just a speed bump.

Someday...there will be no recovery.   So, will the FED pitch in 5-15 Trillion this time to bail out on the insurers?

Wed, 12/09/2015 - 14:52 | 6900516 Bill of Rights
Bill of Rights's picture

" YOU'LL GET NOTHING AND LIKE IT "

 

lol

Wed, 12/09/2015 - 14:56 | 6900533 Squid Viscous
Squid Viscous's picture

something tells me Spaulding went straight to Wall St. after his Ivy League Degree.

Wed, 12/09/2015 - 14:57 | 6900534 Bill of Rights
Bill of Rights's picture

Lol spot on...

Wed, 12/09/2015 - 15:33 | 6900675 froze25
froze25's picture

Can't beat Caddy shack.

Wed, 12/09/2015 - 15:36 | 6900683 prudent1nvestor
prudent1nvestor's picture

What they fail to mention is most of these bonds aren't due until 2018. Post this article again in two years. k thx

Wed, 12/09/2015 - 15:37 | 6900694 SILVERGEDDON
SILVERGEDDON's picture

Goldman is gonna bite some Sachs for Christmas.

SCROOGED YOU AGAIN, MUPPETS.

Thanks for your hard earned cash.

Yours truly, Sir Lloyd The Blankfiend.

Wed, 12/09/2015 - 14:38 | 6900477 corporatewhore
corporatewhore's picture

containment... yep, that's the ticket. worked well in 07/08.  /sarc

Wed, 12/09/2015 - 14:40 | 6900480 GartmansTaint
GartmansTaint's picture

Just give em more money, c'mon, why not? It's a party I tell ya, we got naked Puerto Rican women and enough blow to go around!!!!

Wed, 12/09/2015 - 14:43 | 6900489 GRDguy
GRDguy's picture

Looks like some paper promises are not going to be kept.

Wed, 12/09/2015 - 14:45 | 6900493 Soul Glow
Soul Glow's picture

Dow Jones moves below 17k and Yellen doesn't raise rates.

Wed, 12/09/2015 - 14:50 | 6900510 Uchtdorf
Uchtdorf's picture

Good call.

Wed, 12/09/2015 - 15:17 | 6900623 Soul Glow
Soul Glow's picture

Thanks.  Then a bounce back to mid 17k until the next meeting, at which point it begins to sink and, viola no raise.  A forever cycle until WWIII goes hot.  It will keep stocks treading water, needed to support the ponzi, debt issue will continue to burden the taxpayer for when the collapse does happen, and the dollar loses value sparking economists to say its "good for exports!"

Wed, 12/09/2015 - 15:10 | 6900587 Squid Viscous
Squid Viscous's picture

yes, the last (and easiest) rabbit out of the hat so they can "hold off" on raising 

Wed, 12/09/2015 - 14:50 | 6900506 Jason T
Jason T's picture

when you're borrowing money just to pay the interest, you are fk'ed.

Wed, 12/09/2015 - 14:50 | 6900509 scintillator9
scintillator9's picture

Contained...... LMFAO!!!!!!

 

Wed, 12/09/2015 - 14:51 | 6900515 Bluntly Put
Bluntly Put's picture

No worries genetically modified skittle crapping unicorns will save the day.

Wed, 12/09/2015 - 15:24 | 6900651 leftcoastfool
leftcoastfool's picture

You Tylers are like a schizophrenogenic mother:  on the one hand you bitch about ZIRP, NIRP, and trillions of free money from the Fed propping up everything and causing malinvestment, then you turn around and complain about, "Yellen, who is now about to hike rates and launch a tightening cycle at precisely the time when should be easing further to take away from the pain that will be unleashed by an inevitable junk bond supernova." 

You can't have it both ways.  It's the Fed's easy money policy that created this shitstorm, and it's way past time for it to end.  Bring it on, Janet!  Raise rates and force a correction on this "market". Maybe we need a shitstorm supernova!  Then maybe, if we're lucky, we can rebuild with a bit more sanity...

Wed, 12/09/2015 - 15:49 | 6900728 TheDanimal
TheDanimal's picture

Well as you stated yourself, it's not just one person posting as Tyler.  You ought to be thankful there's some balance to the views here. 

Wed, 12/09/2015 - 15:51 | 6900712 PrimalScream
PrimalScream's picture

ZH:  I have never seen the commodities markets as bad as they are now.  And there is NO conceivable way that the carnage can be contained to just commodities.  

I have also never seen the world this close to a major war.  It's moments like this that you truly come to appreciate how incidents such as "assassination of Archduke Franz Ferdinand" became the fulcrum for WW1.  There are certain moments when key turning points can influence the outcome of world history.  We are sitting on one of those moments right now, with Syria, Turkey - ISIS, Russia and NATO.  And yet all of the world leaders keep singing and dancing the same old songs.

You have pointed out many times ... Austrian economics and the theories of Mises.

We are watching those moments of "deleveraging" in technicolor.  

-----------------

Words from Wikipedia - the start of World War 1 ...

About an hour later, when Franz Ferdinand was returning from a visit at the Sarajevo Hospital with those wounded in the assassination attempt, the convoy took a wrong turn into a street where, by coincidence, Princip stood. With a pistol, Princip shot and killed Franz Ferdinand and his wife Sophie. The reaction among the people in Austria was mild, almost indifferent. As historian Zbyn?k Zeman later wrote, "the event almost failed to make any impression whatsoever. On Sunday and Monday (28 and 29 June), the crowds in Vienna listened to music and drank wine, as if nothing had happened."[

-----------------

Notice these particular words in the commentary ...

 the crowds in Vienna listened to music and drank wine, as if nothing had happened.

Wed, 12/09/2015 - 15:56 | 6900767 Sudden Debt
Sudden Debt's picture

Today, it was 15 degrees celcius in Belgium. Normally, we would freezing our asses of right now.

I actually realized it was pretty hot when I went outside this morning for a smoke in my boxers and shirt.

Then today, I also heard that retail stores are planning 90% discounts on winter clothing after newyear! 90!!!!

And that's not the worst, EVEN CHRISTMASS PARTY CLOTHING IS ALREADY ON SALE!

Almost the entire winter collections are still in the stores. That means a lot of companies will go belly up if it doesn't start snowing.

 

Now, they're also even organising outlet fairs where factories dump their stuff AT FACTORY COST to get rid of their overstock!

It's killing retail even more!

And that are signs that companies are getting desperate. Very desperate because they know that when their clients see they're dumping their goods that they'll never accept stickerprice anymore. 

The stock market doesn't seem to know this right now but man o man... you'd better start shorting retailers because the same shit is happening allover Europe.

 

Wed, 12/09/2015 - 17:37 | 6901236 Squid Viscous
Squid Viscous's picture

El Nino... a temporary reprieve from the impending Maunder Minimum part 2

Wed, 12/09/2015 - 15:58 | 6900777 Comte d'herblay
Comte d'herblay's picture

"Jim Rogers, paging Jimmy Rogers!!!

Please, wherever you are in China, call your office!!"

 

https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&...

Wed, 12/09/2015 - 16:44 | 6900997 Barrack Chavez
Barrack Chavez's picture

Ben Bernanke: From the Fed's perspective, after complex studies by our very large staff of PhD's:

"The subprime contagion appears to be well contained..."

lets all stop a minute and think about how that worked out

Wed, 12/09/2015 - 17:44 | 6901272 surf@jm
surf@jm's picture

Well, when you have companies like JC Penney that have lost money for over 15 quarters, maybe some defaults and liquidations should be allowed to happen......Jeezzzzz............

Wed, 12/09/2015 - 18:25 | 6901454 corporatewhore
corporatewhore's picture

It's a miracle!

Wed, 12/09/2015 - 18:01 | 6901348 UncleChopChop
UncleChopChop's picture

why do people keep saying that yellen should not tighten, but ease? it's a total false choice. the system is broken - period. whether the fed raises rates or cuts them, the system is fucked. thinking that further 'easing' will solve anything is moronic at this point. maybe you had that illusion when rates weren't flirting with zero-bound, but come on.. what needs to happen before people realize the whole fundamental underpinnings of managing the economy with 'monetary policy' is not fubar.

 

maybe if we did a massive reset (shemita or whatever it's called) then theoretically, monetary policy could possibly be helpful. but with the burden being carried now, it's all moot.

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