The low default rate regime lasted for a very long time: 2014 was no exception
In Cross Asset September’s issue of last year we focused on High Yield default rate cycle features and perspectives: we underlined the apparent paradoxical divergence between macro and fi nancial trends of the current default cycle which looks the most benign of the last three decades in spite of Great Financial Crisis occurring. 2014 was no exception at all and was another year of low default “regime”: as the reported graph shows, in eleven of the last twelve years, B-rated and BB-rated annual default rates were not only well below average but they were also close to almost marginal levels. The only notable exception was 2009, the post-Lehman default year, with its short-lived spike.
Moving from short-term (one-year rolling) measures of default rates to longer-term measures (default rates cumulated over fi ve years) the picture, in fact, looks even brighter. The last annual default study published by Moody’s shows that the latest 2010-2014 cohort to complete a 5 year period recorded the lowest cumulated default rate since a long time for both BBs and Bs names. In fact, BB-rated companies cumulated just a 2.1% default rate in 2010-2014, a low number not recorded since the 1988-1992 period: at the same time, B-rated bonds reached a 7.5% cumulated default rate, with previous low recorded in the 5-yr ending 2004. Just to put these numbers in historical perspectives, 5-yr cumulated default rates’ long term averages, depending on the period taken into account, are respectively between 9% and 10% for high quality speculative grade (BB-rated) and between 20% and 23% for the B-rated companies. Each year the cohort is formed of issuers with the same rating category and then its composition is kept stable for calculations, independently of following rating changes that may occur in the 5 years: under this respect it’s a more comprehensive measure of default rates, as it includes in the calculations also the indirect effect of rating migration.
Post Lehman crisis default rates still mainly a CCC story among HY issuers
As the following graph shows, over the last few years that followed Lehman’s crisis, default rates were mainly a low quality (CCC-rated companies) story among speculative grade issuers.
BB spreads, in particular, continue to overcompensate for actual default rates and remain attractive despite low absolute levels, in absence of a renewed risks of a spike in default cycle.
Top-down factors leading European HY default rates
In September’s piece we came to conclusions which seem to have been confirmed by the trend in the last two quarters: in particular, the link of HY default rates with macro growth and monetary policies and the role of financial conditions and bottom up factors in supporting a persisting low default environment.
a. Financial conditions
Actually, in the last two quarters among developed areas, it was the Eurozone that recorded the most important changes in both financial and economic conditions. First of all it was the case of financial conditions, as ECB “precommunicated” QE by late Q4 last year to then finally announce and launch it in Q1 this year. As a consequence, the remarkable depreciation of the single European currency, by itself, represented and still represents a tangible improvement in overall financial conditions. Then, according to ECB bank lending surveys, last two quarterly sets of results showed a widespread improvement in all major Eurozone countries, both in terms of bank lending standards and applied rates on one side and also in terms of recovering loan demand, on the other side. Though the general level of standards are still relatively tight by historical standards, the net percentage of banks declaring to tighten credit conditions to firms has recently dicreased. The success of the third TLTRO, which allocated around double the volume of liquidity expected by consensus, seems to be coherent with these trends, as periphery banks were more active than in the disappointing December TLTRO. This time, for example, one third of the overall new liquidity was requested by Italian banks. Finally, on the financial conditions side, the distress ratio, or the measure of openness/tightness of the HY corporate bond markets proved to be quite resilient to negative effects from US energy names, which greatly suffered at end of last year from the fall of oil price. The distress ratio is represented by the percentage of bonds trading at “distress levels”, namely at or above 1,000 b.p. spread over government bonds. US HY distress ratio rose from 4%/5% to a 13% level, because of its exposure to the oil and energy sector and because of negative effects from stronger USD on exporting companies. On the contrary, EUR HY distress ratio has remained more stable and moved up from 1%/2% to still very low levels of 4%. Finally, one important effect produced by ECB QE announcement was the return of remarkable inflows into funds and ETFs dedicated to EUR speculative grade bonds: these flows contribute to maintain favorable funding conditions and reduce risks of rising market stress.
b. Macro trends
With respect to September last year, the momentum of macro surprises significantly improved in the Eurozone: Q4-2014 probably saw deflationary worries and concerns about a possible third recession peaking. Then Q1-2015 saw quite an improvement in indicators of economic surprises and the recovery of leading indicators. As it leads defaults, the composite PMI represents one of the input factors of our regression model, though failing to achieve the same level of statistical significance typical of financial conditions, both banking and bond-market related.
Our regression on European HY defaults
On the back of these considerations, we re-run our regression model which projects default rate over a four quarter horizon. The reported graph shows that a stable picture for European default rates looks the result of recent trends of considered factors, namely the composite PMI, the percentage of banks tightening lending standards and the distress ratio. According to Moody’s data, Q1 ended with European default rates at 2.2%, slightly higher than Q4-2014 close at 1.8%. Moody’s expects the same default rate to close 2015 at 2.4%. According to our regression, the default rate could even be lower than today in four quarters’ time from now, at around 1.6%/1.8%. As we pointed out in previous publications on this topic, European HY companies have proven to be quite resilient to negative macro and financial effects produced by the sovereign crisis for a number of reasons, mainly linked to the defensive composition of its universe (for example: size, business model, ratings, countries represented). These factors explain the gap between modelled and actual default rates that has taken place (see the graph) after the sovereign crisis.
To conclude this part, we’d like to underline that the combination of macro growth momentum and financial conditions still look supportive for European HY speculative grade. In order to experiment a spike in defaults, a negative shock from a sudden recession and/or a sudden and rapid tightening in financial conditions would be needed. Both of these scenarios, however, in light of recent macro indications and ECB on-going QE look unlikely at the moment.
BB spreads remain attractive
Positive macro momentum and improved financial conditions reduce default risks