One of the surprises in recent years is the level of corporate defaults. Despite a pandemic and collapse in output through 2021, corporate defaults have stayed surprisingly low. Near-zero interest rates and heavy government support ensured that refinancing could be undertaken for many challenged businesses.
The key question is whether this is going to continue. We know the answer to one part: interest rates have not been maintained at rock bottom levels and are unlikely to return there any time soon. Further, the extreme fiscal measures undertaken during Covid and more recently to stave off an energy crisis have ended or are reducing. Corporates will have to stand on their own two feet.
If we look at high yield corporate America, we can see a pick-up in defaults in Q1 2023. The preceding two years saw defaults running at less than half the average rate seen from 1997 to 2022. So far this year we have seen 10 defaults, with a default rate now above 2%. This is still low by historic standards – which has been around 4% – and a lot lower than the 8-12% seen in a typical recession. But the trendline is moving up.
Does this mean it is time to get nervous on credit defaults? Let’s look at where high yield defaults could go and how much compensation investors are paid to take this risk. On the first point there are reasons for optimism. The Covid period created a small mini credit cycle which both bolstered and cleansed the cohort. Take energy, as an example; the sector is more robust than it was pre-Covid, helped by a changing composition – with larger and more robust companies. Indeed, this can be applied to the wider high yield universe. CCCs (at the riskier end) now make up less than 10% of the market, half the weighting seen around the Great Financial crisis (GFC). Conversely, BBs (the higher quality end of the market) now represent more than 60% of the market. As an additional plus, high yield credit issuers have, on balance, looked to extend maturities rather than using low yields to increase leverage. What this means is that US high yield leverage is at a 15-year low and interest coverage, at 3.5x, the best in recent memory. We should also consider the expansion of private credit markets which has been one of the most significant growth areas recently. This area has absorbed some of the more problematic and leveraged issues – shifting part of the default risk away from public markets. Taking all this into account my colleague Azhar Hussain, Head of Global Credit, sees a high yield global default rate of 4-5% this year. I would recommend Azhar’s monthly commentary for updates.
What about valuations? There have been three spikes in high yield credit spreads over the last 25 years: 2002, 2008 and 2020. In each, my preferred measure of high yield credit spread exceeded 10%. Today the spread is 5.6%, representing a slight premium to the average of the last 10 years and up from 3.5% in mid-2021. This means, in my opinion, that high yield looks attractive given the improved quality of the universe and only a modest upwards trend in defaults. What would derail this is a hard landing. And this can’t be ruled out despite the better recent data.
Investment grade is yet another story. Here we are lending to the top cohort of global issuers and the main threat is downgrade rather than default. My preference remains for investment grade bonds over high yield but I would expect both to outperform government bonds on a medium-term view – given where we are starting from.
Last week the Federal Reserve (Fed) duly delivered its expected 25bps rate increase, taking the target to 5-5.25%. Whilst leaving the door open to further hikes there was a hint of a June pause. The quandary faced by the Fed is not unique: a view that inflation is proving sticky (Fed Chairman Powell: getting back to 2% has a long way to go), robust labour markets yet concern about the lagged impact of past monetary tightening. Friday’s employment data compounded the dilemma. With unemployment matching a 50-year low and average earnings moving higher, it looks to me that a Fed Funds rate of 4.25% by year end, as implied by markets, is optimistic. What could change my view is renewed trouble in the US banking sector. After a short lull, last week saw the 'rescue’ of First Republic and severe share price weakness in other regional banks. This nervousness will impact bank lending decisions, implying tighter financial conditions, and taking some pressure off the Fed to do more.
Is there sign of contagion? A headline showing sizeable cash withdrawals from UK banks in March would suggest some impact – it being the first outflow of bank deposits in almost five years. And there was a net £3.5bn inflow into National Savings – where all deposits are government guaranteed. But to ascribe this to concern about UK banks would be misleading. The interest rate differential must play a part: for instant access that differential is now around 2%. Time for banks to start recognising the new interest rate world?
Government bond markets were little changed over the week. US 10-year yields ended at 3.5% whilst the German rate was steady at 2.3%. UK nominal yields were a bit higher and real yields underperformed, with 20-year implied inflation moving lower to 3.4%. Sterling continues to defy the currency forecasters, hitting a one-year high of 1.26 against the US dollar.
Credit markets were, for choice, weaker. This was most noticeable in high yield where spreads widened by around 20bps. In investment grade there was weakness in financial bonds with renewed pressure on US regional banks but broader indices were not much changed.
I think the Bank of England is likely to move Bank Rate to 4.5% this week, with further hikes priced in. Overall, I remain cautious on the ability of the UK economy to shrug off this tightening.
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