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HY default rates: a reality check and what to expect

 

THE ESSENTIAL

 

Defaults seem to have turned the cycle in the US, but the recent rise is still very much a low-rated, commodity-driven story and not yet a broad-based trend. However, signs of rising stress are also emerging from sectors that are not commodity-driven, and we project a 6% US HY default rate by year-end, half of it attributable to commodity-driven sectors and half due to a limited rise in defaults in other sectors. Europe, in contrast, is seeing a much more stable picture, not least due to the latest measures taken by the ECB.

In this piece, we focus on current and future trends in default rates on both sides of the Atlantic, looking at a combination of topdown and bottom-up factors and deepening the analysis on sectors and ratings. We also analyse the specific characteristics of this cycle with regard to recovery rate trends and the effects of recent re-leveraging trends in credit metrics. Finally, we address the topic of valuation on a pure default risk basis for both long-term and short-term investors.

 

PUBLICATION

 

Current trends by region, sector and rating

Defaults rising in the US, stable in Europe

Global default rates are still low. Apart from the notable exception of 2009, they have been below their long-term average for more than 10 years. However, 2015 and Q1 2016 saw a rise in bankruptcies and showed signs of a cyclical shift in the US. Meanwhile, European speculative grade defaults remained comfortably stable and close to previous years’ troughs, showing no signs yet of closing the gap with US HY debt.

US defaults also low if commodity sectors are excluded

A deeper look into USD-denominated speculative grade debt shows that if commodity-driven sectors are excluded from the calculation, default rates have remained stable and historically low in the US as well. The first graph shows that the rise in defaults by US speculative grade issuers over the recent quarters has been concentrated in energy and metals & mining. According to data by Moody’s, as of Q1 2016, energy and metals & mining had default rates of 10% and 12.6%, respectively. This brought average default rates on US HY debt to 4.1%. Excluding these two sectors, the ratio would be around 2.5%. Thirty-three Moody’s-rated issuers defaulted in Q1 2016 according to the rating agency, compared to only 22 in Q1 2015. Roughly two-thirds of these issuers were from oil & gas and metals & mining. Twenty-seven defaults (82%) came from the US, and just one default was recorded in Europe.

Still very much mainly a CCC-rated story

Quality, or rating, is another important factor to consider when trying to put the recent trends into perspective. BB and B-rated defaults are still considerably lower than their long-term averages, and credit events have so far been predominantly low-rated or “junk” stories. Despite rising to 3% and 0.8%, respectively, B and BB-rated defaults are still very far from average recessionary levels and are showing no signs of accelerating, unlike CCC-rated bonds, which have suffered from an acceleration in bankruptcies.

European and US perspectives

European defaults to remain low thanks to both bottom-up and top-down factors

Taking into account both of these factors (sectors and ratings), the default cycle in the US does not yet seem to be undergoing a convincing, broad shift. At the same time, the prospect of a sizeable rise in defaults in Europe appears highly unlikely. Not only is the exposure to the sectors currently driving up defaults in this cycle quite limited, but, even more importantly, the quality factor is playing and will continue to play a substantial role in differentiating the perspectives of the two markets. BB-rated debt represents two-thirds of the entire EURdenominated market, while CCC-rated debt occupies only a small share. The recent changes in the composition of the European market have given much more stability to European speculative grade debt compared to before. During the tech bubble, for example, the EUR HY market was more exposed than the US market to the sector in the eye of the storm. For this reason, defaults at that time reached higher peaks in Europe rather than in the US. Bottom-up factors clearly play a crucial role in the divergence of default prospects between the US and Europe, but top-down factors also need to be taken into account. These include the different credit cycle phases that US and European bonds are currently going through (mature with leverage increasing in the US, Europe still in the midst of deleveraging), diverging monetary policies (the Fed likely to gradually raise interest rates again, the ECB recently delivering QE2 in a strong show of support to corporates) and bank lending criteria (trending easier in Europe, tighter in the US). The top-down factors, like the bottom-up factors, all place Europe in a better position than the US.

The ECB’s latest move further reduced default risks in Europe

Default risks in Europe had already been low prior to the ECB’s move. With the recent measures directly and indirectly supporting corporate bonds, the prospect for a stable and low default rate in the eurozone is even more secure. Consider the following:

  • The ECB’s measures have already benefited corporate technicals on both the demand and supply sides. A total of €4 billion have already flowed back into HY dedicated funds and ETFs, occurring within weeks of the ECB’s announcements. These inflows have supported the return of demand for new issuances, which the primary markets finally received in substantial amounts. After many months of poor or no issuances, primary market volumes are likely to accelerate in the coming months.
  • Distress ratios fell alongside spreads, including in Europe, though from lower levels than in the US.
  • TLTROs and other measures are likely to maintain supportive bank lending criteria on NFC loans, as confirmed by the most recent ECB survey. 
  • The inclusion of IG non-financials in the asset purchase programme reducesthe downgrade risk and the risk of a rise in the number of fallen angels. In this respect, the divergence between the US and European markets is growing and likely to grow further. The third graph shows that the volume of debt falling from IG into HY jumped in the US last year, a break from three years of stability,from USD 60 billion to USD 151 billion. Q1 2016 alone saw a record volume of USD 93 billion, or 61% of the 2015 total. In contrast, after hitting the peak of the sovereign debt crisis in 2012, the volume of issuers downgraded to speculative grade status in Europe has fallen consistently. Last year it was the equivalent of just USD 35 billion, in stark contrast to the 2012 peak of USD 80 billion. In Q1 of this year, despite more challenging funding conditions until the ECB took action, fallen angels represented a volume of just USD 18.9 billion.

Default rate to rise further in the US

We also have to consider the extent to which bond markets are open and receptive to issuers. One of the main factors influencing default rates is the percentage of bonds trading at or above 1,000 bp spread, or the distress ratio. In light of current spreads, a further rise in defaults in commodity-driven sectors is highly likely. In other words, the default trend in energy and metals & mining is not yet over, and despite the recent recovery, the current price of oil will continue to put pressure on exposed companies. And despite a partial fall, the distress ratio of US energy companies is still at historically-high levels. Though down from a peak of 70%, a considerable majority (60%) of bonds are still trading at distressed levels, which means the default rate will probably rise to new highs in around one year’s time. The same is true for metals & mining, as the second graph shows. Examining the energy sector more closely, the risk of default is most likely to materialise in exploration & production and in oil field equipment & services, whose shares of the overall debt amount to 43% and 20%, respectively. This is especially true of these sub-sectors’ CCC-rated debt. 14% of the overall energy sector is represented by CCC-rated debt from the exploration & production sub-sector, and 3% and from the oil field sub-sector,
the most vulnerable to low oil prices.

While most other sectors still have very low and stable default rates, distress ratios recently rose on more than just the two “usual suspects”. Despite the recent rally in energy sector, retail, capital goods and media started to feel some pressure and look set to experience a future rise in defaults. These three sectors are likely to contribute to the rise in defaults over the coming year as their cumulative weight in the benchmark reaches 21%.

Our top-down regressions continue to point to a 6% average default rate for US HY by year-end and Q1 2017, half of it represented by commodity-driven issuers and the other half by all other sectors, especially the three cited above.

 

The latest projections from rating agencies confirm our forecasts in both regions

Both Moody’s and Fitch point to a considerable divergence in default rate trends between the US and Europe over the coming quarters. On the back of progressive upward revisions in recent months, Fitch and Moody’s indicate that the same is likely for US speculative grade default rates by year-end, namely 6%. This number is very much in line with the result of our regression based on the distress ratio, bank lending criteria and debt growth. Likely due to the different universes used for rated companies, the two rating agencies’ forecasts for European default rates differ on the rate level; however, they concur on the decoupling between European and US rates. Moody’s currently forecasts a 2.1% default rate by December 2016, down from 2.6% in March, while Fitch forecasts a rate below 1% by market value and below 2% by the number of bonds. Fitch published a trailing 12-month EUR HY default rate of 0.7% by December 2015, lower than the figures recorded by Moody’s over the same period. Fitch cited themajority (67%) BB-rated composition of outstanding bonds as a factor keeping default rates low. The Fitch numbers are also in line with actual defaults by the most widely-tracked market benchmarks, showing a considerable gap between the US and Europe.

New risks, old risks and a look at market valuations

The recovery ratios of defaulted issuers are quite low by historical standards

A peculiar trend in recent months has been the apparent dissociation between default rates and recovery ratios. Usually, these are negatively correlated: in a nutshell, when defaults are historically low (like in current times), recovery ratios are above average, while the opposite occurs when defaults reach peak levels, like in recessionary phases. However, despite the fact that default levels remain at historically-low levels in the US, recovery ratios fell quite significantly in 2015 andin Q1 2016. Over the recent quarters, the recovery ratio has fallen to 20:30 from its earlier level of around 50:60.

Default levels are not the only drivers of recovery ratios. Bottom-up factors and credit metric trends can also play a significant role. In this respect, the growing concentration of credit events in just two sectors is one part of the story. In fact, according to Fitch, the recovery ratios of defaulted companies in the energy and metals & mining sectors were an average of 22.9 and 17.3, respectively, in 2015, substantially lower than the overall US HY average recovery ratio of 31.3. The figure fell even lower to just 14.2 for metals and mining companies that defaulted in Q1 2016. Furthermore, if we separate credit events into “traditional” defaults on the one hand and DDEs (distressed debt exchanges) on the other, the recovery ratios plunge to 16 and 12 for non-distressed debt exchanges. In addition to the sector-driven aspect, the second reason for such a break with the past is the fact that this cycle has been relatively poor in terms of capital spending. Debt has recently risen, but assets not nearly as much, and this has inevitably increased the proportion of liabilities to total and tangible assets.

Risks from recent trends in credit metrics and the purpose of new issuances

In previous publications, we emphasised that the credit metrics of US nonfinancial companies had deteriorated over the preceding quarters. The debt-toincome ratio rose on the back of expanding debt growth at a time when profi t growth slowed down. The last two quarters even recorded a contraction in US NFC profits, though due to the energy and materials sectors. Furthermore, the US speculative grade primary market saw a substantial increase in the proportion of new debt issued for LBOs and acquisitions. Refinancing, which was the purpose of most new HY issuances between 2009 and 2013 (in the 60% to 70% range), fell to a lower proportion (51%) in 2014, and even lower in 2015 (42%) and Q1 2016 (38%). In contrast, over the last two years, the percentage of new debt raised or spending in M&A and acquisitions has significantly increased, reaching the current level of 64%.

 

Implied default rates in current valuations still show value, especially in highly-rated issuers

Despite major recent spread tightening, long-term buy–and-hold-focused investors still find value in current credit risk premiums on a pure default riskadjusted basis. We ran an analysis focused on a 5-year horizon and used two different recovery rate assumptions: 40% as a long term average and 20%, which is more in line with the recent trends presented in an earlier section of this piece. In the case of a 40% recovery rate, the current spreads offered by BBs and Bs cover not only the historical average default rates but also the weakest five years on record, in both the European and US universes. However, if the assumed recovery ratio is lowered to just 20%, current spreads no longer cover the weakest five years but vastly exceed historical averages and recent figures. For example, current spreads cover a cumulative 18% default rate over the next 5 years for European BBs and a 20% rate for US BBs, double the 9% historical average default rate and much higher than the 2.2% total over the favourable last five years. B-rated spreads are paying for a 31% 5-year cumulative default rate with a 20% recovery ratio, above the 20% historical average and much higher than the 7.5% rate of the past five years. The most interesting aspect of this analysis, in our opinion, is the gap between the US and Europe, especially on B-rated bonds, which are more exposed than BBrated bonds to extreme credit events. US and European spreads point to very similar trends in defaults over the next five years, but our previous analysis suggests a decoupling between the two trends, greatly in favour of Europe. If the horizon is shortened to a one-year/two-year period, valuations on a pure default risk basis appear very much in favour of highly-rated speculative grade bonds, especially in Europe.

Conclusion

Defaults seem to have turned the cycle in the US, but the recent rise is still very much a low rated commodity-driven story and not yet a broad-based trend. However, signs of rising stress are also emerging from sectors that not commodity-driven, and we project a 6% US HY default rate by year-end, half of it attributable to commodity-driven sectors and half due to a limited rise in defaults in other sectors. Europe, in contrast, is seeing a much more stable picture, supported by both bottom-up and top-down factors, including the latest measures by the ECB. A decoupling of default rates is therefore likely between the two sides of the Atlantic over the coming quarters, with risks in the US also posed by below-average recovery ratios and the effects of recent releveraging trends in credit metrics. Despite the recent rally, current valuations are still attractive over a long-term horizon. However, relative to the expected trends in defaults, they appear more attractive in Europe than in the US on a pure credit event risk-adjusted basis. Highly-rated BB bonds appear particularly attractive in the short term.

 

 

 

B and BB-rated defaults are still far from recessionary levels and are showing no signs of accelerating

 

 

 

2016-05-04-1

 

2016-05-04-2

The ECB’s latest move further reduced default
risks in Europe

 

2016-05-04-3

 

2016-05-04-4

 

2016-05-04-5
2016-05-04-6
2016-05-04-7
2016-05-04-8

 

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BERTONCINI Sergio , Head of Rates & FX Research
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HY default rates: a reality check and what to expect
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