Crisis Year 7 - The Japanization Of Credit

2013 is likely to be the seventh year that the financial world operates under extreme conditions/stress and increasingly heavy intervention.

Via Deutsche Bank:

A holistic view of the crisis


Since the crisis first began in 2006, developed world equities are still lower, real GDP has struggled to grow above its pre-crisis peak in most countries, core bond yields are sharply lower with peripheral yields higher and with credit yields generally performing well albeit it with fairly extreme volatility. Credit has been helped by the fact that the authorities way of dealing with this crisis to date has been through money printing and liquidity facilities to help prevent mass defaults which, as is is clear in the chart below, has led to a weakening in the normal relationship between GDP and defaults. Defaults should have been a lot higher given the macro environment.


Default rates vs GDP - correlations have broken down...



Ripping up what we know on defaults – Could Japan be the template for credit?


One way central bank activity has made a dramatic impact on markets so far is in ensuring that defaults have remained significantly below where they would have been had central banks remained dormant. Up until the last two or three years, those of us that have spent our career looking at Western credit markets (US, UK and Europe) have generally assumed a reasonably strong correlation between GDP and defaults in each region. However through a combination of; i) divergent developed (weak) and EM (stronger) market growth but with increasingly global companies; ii) artificially low rates; and iii) most importantly the supportive action of the authorities, it’s fair to say that we’ve had to reappraise our default methodology and assumptions downwards. This is in spite of the fact we have a developed world where growth has ground to a halt across most countries with many in recession.


The correlation between GDP growth and defaults in both the US and especially in Europe seems to be weakening. In the US and in Europe it could be argued that the defaults were already artificially low prior to the financial crisis given the credit bubble (structured credit etc) and after re-coupling back to normality during the financial crisis it seems we again have much lower defaults than the anaemic growth environment suggests. This is perhaps even more extreme in Europe where we have a recession overall and a slump in some member countries, yet we still have very low default rates. One saving grace is that global activity has remained stronger than western growth.


So stronger global than domestic growth has clearly been a factor in lower defaults relative to the domestic growth environment but in 2012 global growth has dipped without an increase in defaults. This perhaps shows the impact that the authorities are having on defaults. It’s also fair to say that corporates have spent a decade terming out their debt which makes them more resilient to funding shocks than say financials and sovereigns.


Japan-isation of credit?


One of the features of the last 20 years in Japan’s post-bubble adjustment and lost growth period is that defaults have remained very low. It’s not easy to compare credit markets across borders as the rating compositions vary. Japan for example (as seen in the chart below) does not have a HY market on the same scale as the US and Europe.


5-Year average cumulative defaults since 1981 for All IG and Single-A Companies...



Over the past 30 years, it’s impressive that Japanese defaults have generally been below their international peers in spite of a couple of lost decades of growth. The Japanese way of propping up entities that would otherwise have succumbed to free market defaults has certainly spread to Europe and the US over the last five years.


We can’t help thinking that this has contributed to a lower default rate post-financial crisis and Japan shows that it is possible to keep this up for a very long period of time. So it seems likely that even if growth is as weak as we expect it to be, as long as money printing props up the debt market, defaults are likely to be much lower than the underlying economic environment suggests they should be.

This could carry on for some time.

However, as we noted previously, the mark-to-market volatility on the way may just become too much to bear for all but the most long-term bond rotators.

Source: Deutsche Bank