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 prots, 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.