AAM Viewpoints: Corporate Default Rates
With what many are calling the maturation of the current economic cycle, is the corporate default rate on the precipice of taking off? S&P is already calling for a 30-35% probability of a recession by the end of 2020. Economic data does show a slowing down while the proportion of high yield companies issuing debt is growing. Did we reach an inflection point where one should pull back on corporate credit waiting for the collapse?
Many in the market are pointing to clear and growing danger signs as it pertains to the global, and especially, the U.S. corporate default rate. Currently the global default rate remains quite benign, with Moody’s having the high-yield trailing 12-month average global corporate default rate at 2.4% compared with a 20-year average of 2.8%. S&P is posting similar numbers with a current global default rate of 2.1%.
The U.S. speculative grade default rate remains quite benign as well, with the Moody’s and S&P default rates for September 2019 at 3.2% and 2.8%, respectively.
However, there are weaknesses in some recent economic data, especially in terms of construction spending and manufacturing, where the latest institute for Supply Management’s (ISM) manufacturing purchasing managers’ index indicates a contraction.
Many point to an inverted yield curve as another danger threatening the current benign default rate environment. An inversion of the yield curve – defined as the difference between the yields on 10-year Treasuries and three-month Treasuries – has been a successful indicator to a recession in the United States in the past, having preceded the last seven recessions by an average of about 10 months. This, in turn, has led to spikes in the default rate.
Additionally, the growth in high-yield debt issuance in recent years has been a growing concern. According to S&P data, at the end of the 2nd quarter of 2019 (2Q19), the proportion of speculative-grade issuers with ratings of 'B-' or lower reached nearly 28%. This matches the high seen at the end of first quarter of 2009 – a point in time already deep into the recession where the U.S. high yield default rate was much higher than today – 8.5% and 5.8% by Moody’s and S&P respectively, and on its way into double digits.
Finally, other observers are looking at the difference between current core pre-tax profits and the drop from the peak. Moody’s Analytics has called this a reliable indicator in the past and has led to increased default rates.
Are we now destined to accept a spike in the high yield default rates given the aforementioned warning signs?
Liquidity is king and will likely keep the default rate from rising precipitously. Liquidity is linked to benchmark interest rates and Treasury yields. Therefore, while debt as a percentage of GDP is high, interest rates and Treasury yields are quite low and expected to be even more accommodating in the months to come.
These low interest rates have the potential to ensure ample liquidity for the weakest companies and will likely suppress sudden rises in the default rates.
Growing corporate leverage has been a concern, and while this may be true in certain sectors (autos, retail, consumer services), this problem appears to be contained overall, with liquidity, interest expenses, and debt coverage all within reasonable levels.
Moreover, while corporate profits have come down from their peaks, they remain quite healthy and in fact, improved in 2Q19.
Based on the latest economic indicators, the economy – highlighted by an excellent employment profile and modest inflation – appears far from a recession, in our opinion. Absent that recession, there is little indication that a spike in the default rate is imminent.
Another factor, near-term debt maturities, appears to be quite manageable as many issuers prepaid their near-term refinancing needs in the early days of the Fed's interest rate tightening campaign, while corporate yields remained little affected.
Finally, Moody’s states that the “incidence of U.S. high-yield credit rating downgrades relative to upgrades sometimes offers insight regarding the nearness of a business cycle downturn.” We have not reached the point where this downgrade-to-upgrade ratio would indicate recessionary pressures.
Despite some stressors increasing recently, especially the rise in corporate debt, an exploding default rate scenario is still not likely given economic growth (albeit slowing), low corporate tax rates, still manageable leverage, and room for more monetary stimulus. Robust corporate profitability, scant unemployment and low interest rates are just a few of the factors helping to tame risks tied to the boom in corporate borrowing. In other words, the U.S. corporate market remains strong, reinforced by high corporate proﬁtability, exceptional employment conditions, low interest rates (now falling), and tame inﬂationary pressures. The banking sector is re-capitalized and credit channels are “open and ﬂowing” per IHS Markit. These have the potential to keep the default rate at benign levels for the foreseeable future.
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