Defaults and dislocation

The bad news first: we start the second quarter with dark clouds gathering. The ECB has pulled out negative rates as its last available weapon to re-energise European economies. UK GDP growth forecasts have been revised downward again. Many companies are complaining of the most difficult trading conditions since the credit crisis. There’s talk of an “Atlantic earnings recession” and investment bank profits have fallen precipitously. Global high yield bond yields are basically, volatile with the trajectory uncertain.

And yet…default rates for speculative grade companies have not risen. Companies that do need to raise capital find there is a glut of liquidity in all but the highly speculative part of the high yield bond market, and the cost of debt for investment grade companies remains at very low levels. Is the really bad news in credit markets still to come?

Coming off a high

The high hopes of 2015 were short-lived and the first quarter of 2016 was anything but smooth sailing. Since the turn of the year, we have seen ECB dive deeper into the world of negative interest rates with 10 basis points reduction to -0.4%, not ruling out “the possibility and prospect of further cuts if warranted”.  Banks paying to deposit money is a pretty strong signal of capital market dislocation.

Meanwhile, The Bank of England showing no sign of shifting from its record breaking period at 0.5%. There’s little indication this will change until 2017, at the earliest given the downgrades to UK growth expectations we saw recently from the OBR. This leaves the Fed policy divergent, but with the committee increasing divided in its views on the outlook.  It’s a strong recipe for market volatility.

What yields are telling us?

Concern has inevitably transferred onto capital markets. European speculative grade bond yields have seen an increase since the first half of 2015, with published spreads peaking at 636 bps in late Feb 2016 compared to 388 bps in June 2015 and currently 505 bps, driven by concerns over anaemic earnings growth the risk of credit shocks rising.

Rating downgrades have indeed increased: in the past three months S&P has had double the number of downgrades than upgrades in the European speculative grade market– surely a sign of trouble ahead.

Nevertheless, the surge of actual defaults has not yet arrived, taking the edge off the spreads. During March, S&P announced the European speculative grade default rate remained unchanged for the previous 12 months, at 1.4%. This isn’t just a strong 2015 still carrying Q1 2016, the data shows no defaults in 2016 to date – compared to 10% in 2010.

A dislocated time

We live in a period of capital market dislocation. The root cause is slow economic growth and consequent central bank action. The symptoms have, until very recently, been a dramatic fall in investment grade yields and a rush of liquidity deep into speculative grade territory. For many companies this is a form of capital market dislocation that has worked out quite well, so long as they have been insulated enough from the underlying cause of sclerotic growth. Unfortunately, for some companies the growth problem is starting to loom large.

It may well be a difficult few months ahead – there are many macro global drivers at play over the coming months in all corners of the globe – until these issues are understood, taking a call on the health of our credit markets is going to be a difficult call.

 


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