A commodity-led US HY default cycle.
According to the latest numbers published by rating agencies, in H1-2016 default rates accelerated in relation to 2015. However, as it occurred last year, the deterioration of the default cycle is not a global theme, being mostly concentrated in North America. US issuers and in particular, oil & gas and metals & mining companies once again accounted for the lion’s share of the sharp rise in credit events.
Let’s therefore have a look at the latest numbers, starting with the US…
According to the latest monthly report published by Fitch Ratings, the US HY default rate exceeded 5% last July, higher than the 3.4% recorded in December 2015. The comparison with last year is probably more telling considering both the number of defaulted issuers and the overall amount of defaulted debt. In the first seven months of this year, in fact, 112 US issuers defaulted vs. a much lower number of 74 issuers in the twelve months of 2015. Also, the amount of debt involved in defaults had already reached a par value of $75.2 billion in July, against $48.3 billion for the whole of 2015. Energy and metals & mining drove defaults up in the US even more than in 2015: according to Fitch Ratings, the energy sectors reached a default peak of 16% in July, more than double the figure recorded in December 2015, 7.2%, while metals & mining reached 16.4% vs. 10.7% at year-end 2015. Around 70% of year-to-date defaults in the US concerned commodity-driven companies: excluding these companies, the default rate is much lower and still close to 2%, very much in line with the levels recorded between 2011 and 2014.
…and then moving to Europe
As we mentioned above, globally, defaults remain mostly concentrated in the US: 74% of the issuers that defaulted in the year to date were North American companies, 20% were from emerging countries, while only 6% were European companies. The gap in default rates between the US and Europe, therefore, increased further.
S&P’s speculative-grade default rate in Europe eased further in July to 1.3%, while Fitch Ratings published a 1H16 default rate of just 0.9% for European speculative-grade bonds. Also the very latest numbers from Moody’s confirm the deceleration of default rates in Europe, though to a level still slightly above 2%. Limited exposure to commodity-driven companies, the dominance of highly rated names, the supportive effects of ECB policy and improving growth continued to boost the de-coupling of Europe vs. the US default cycle.
Our projections on US default rates: a 6%/6.5% peak likely to be reached in Q1 next year, then a fall back to around 5% in the following two quarters
Among major drivers of default rates, the distress ratio plays an important role, especially in the US where the bond market has become the most important funding channel for corporate bonds. As we outlined in previous publications, the distress ratio is represented by the percentage of bonds trading at or above a 1,000 bp spread over the corresponding risk-free bonds: if the risk premium rises to such levels it means that funding becomes really difficult for a company as the market is implying a high probability of default. The time lag between the rise in the distress ratio and the subsequent rise in defaults is usually one year: this is important as the recent trend in distress ratios is likely to lead to a peak and to a subsequent fall in default rates in the US. The percentage of bonds trading above 1,000 bp spreads, in fact, reached a peak of 31% in February, very much coinciding with the oil price lows: since then, thanks to the recovery of oil prices and receding fears about the macro picture, the distress ratio has steadily fallen, while spreads have tightened, finally halving from their peak to the current 15% level. The fall in the distress ratio was spread across all sectors, but the biggest improvement took place in commodity-driven sectors: energy saw its distress ratio rising to a 75% peak in February, and as we are writing, despite still being high, it is close to 37%. The four-quarter lag between the driver and the explained variable points to a peak in defaults in Q1 2017 and to a subsequent fall in the following quarters. The other variables explaining default rates, in fact, did not show significant changes in the last months: the percentage of banks tightening lending standards was almost unchanged while corporate debt growth does not represent a material change in the regression we run. A look at the graph shows that according to our regression, the US HY default rate should reach a peak in the 6% area in Q1-2017, and then it should fall back to the 5% area by Q3-2017. Moody’s projections seem to confirm this trend, pointing to a further rise from June’s rate of 5.1% to a peak of 6.5% in the default rate by January 2017 and then to a fall to 5.3% in June 2017.
Default rates of European speculative-grade companies to remain low in the next quarters
Our regression on European HY does not show a change in the expected trend of default rates; input factors remained quite stable in the last months, despite Brexit uncertainties and market volatility, also thanks to ECB CSPP. Bank lending standards improved slightly, the distress ratio remained relatively stable together with debt growth, while leading macro indicators were also stable. The outputs from our regression remain stable and slightly below 2% over the next four quarters, and these levels are in line with the current European default rates published by S&P as mentioned above. Moody’s recently stated (see the June Default Report) that the rating agency does not expect Brexit to trigger a sharp spike in corporate defaults globally, adding that: “We expect the default rate to climb to 6.4% at year-end in the US while falling to 1.9% in Europe reflecting only transitory, if any, effects of Brexit”. In its August issue of the European High-Yield insight publication Fitch Ratings projected the European HY default rate would close 2016 in a range between 1.0% and 1.5%. Our regression actually points to 1.7% by December this year and then to very similar levels, between 1.5% and 2%, one year from now. Low exposure to commodity sectors and other bottom-up factors continue to play quite a role in keeping defaults from rising in the Eurozone: consider for example that default rates of US BB-rated names are very close to just 1%, while defaults of B-rated and CCC-rated names have risen respectively to 5% and 15%. As BB-names account for two-thirds of European benchmarks, this helps to explain the very low and stable level of defaults inEurope, along with the limited exposure to the energy sector.
Moody’s doesn’t expect Brexit