“Our cycle indicators signal a default wave is imminent,” says Deutsche Bank in its annual default study:
The tightest Fed and ECB policy in 15 years is running into elevated corporate leverage built upon stretched profit margins. This is especially true in the leveraged loan market, where LBO leverage was juiced higher year after year (after year) by zero rates and central bank QE. And while maturity walls were immediately termed out in the aftermath of the Covid pandemic, tight financial conditions since 2022 have changed the story
Last year’s report was all about how higher inflation would end the 20-year supercycle of low corporate defaults. In this year’s edition, Deutsche strategist Jim Reid and team sketch out the late-cycle hangover where credit losses rise steadily through 2023, followed by a more sharp deterioration in 2024 as the US enters a recession:
Deutsche’s projections are for the default rates to peak in Q4 2024. The models “merely presume a return of the Boom-Bust cycle, not a GFC-style banking system collapse”:
Europe does slightly better than the US because of more fiscal support and less techno-froth.
The recession indicator is flashing because among non-financial corporates, leverage is rising and interest coverage is falling, while bank loan delinquencies are up and lenders are tightening criteria. These are all proven and reliable recession signals, so once Fed hikes work their way through to corporate interest rate coverage ratios later this year it’s silly to assume any other outcome than the norm:
Will the Fed ride to the rescue again? No, Deutsche says, because the coming US recession will be more like the dotcom bubble than the GFC:
Corporate leverage is elevated. And global credit markets derive more of their revenue from manufacturing and the sale of physical goods than the real economy at large. Going forward, corporates will likely lose pricing power on their sale of physical goods, due to high inventory builds and a post Covid demand shift from goods to services.
But labour costs are likely to remain sticky, because of a shrinking working-age population and a desire for consumers to recoup nearly 2 years of negative real wage growth. This scenario will 1) pressure profit margins & 2) prevent the Fed/ECB from riding to the rescue with open-ended QE (given still sticky wage costs). Hence, a more shallow nominal GDP trough + high leverage + less policy support could lead to a substantial decoupling between the real economy and the credit markets during the next recession.
It’s the length of the boom that makes this bust unusual, such as with the amount of leveraged buyout debt swilling around. The period between 2014 and 2021 was equivalent to the pre-GFC buyout rush but went on for eight consecutive years, leaving behind a wall of LBO loans to climb, Deutsche says:
The post-crisis consensus bet was to LBO companies in non-cyclical sectors. The result is concentration risk. A third of US leveraged loans are in tech, healthcare and business services, so the US will be “uniquely exposed” if non-cyclical defaults rise more than expected:
What about all those extend-and-pretend debt refinancings over past few years? Hasn’t the can already been kicked?
There are two concerns we have with this thesis. First, maturity walls are not the primary driver of defaults; unsustainable capital structures are. Particularly in a world where private-equity firms control a substantial share of loan issuers, distressed exchanges are possible before a company has an impending maturity due. Second, 2022’s rate shock and 2023’s growth fears have enforced persistently tight financial conditions on leveraged corporates for the past 18 months, leading to a paucity of new issuance and refinancing activity.
It’s no good having three years to maturity when refinancing’s shut for the foreseeable and there’s a recession on the horizon. Debt with less than one year remaining becomes current on a company’s balance sheet, which triggers the rating agencies, so the runway before investors start to panic is 18 months at best.
For a lot of junk issuers, short runways might be a problem:
The original purpose of Deutsche’s default study series when it was launched 25 years ago was to estimate what corporate credit spreads were required to compensate a patient buy-and-hold investor for average default risk. But figuring out what’s in the price is complicated. This year, of example, investors seem to think the problem will be contained.
Since the mid-2022 growth scare, approximately 10 per cent of US and European speculative-grade debt has been trading below 80 cents in the dollar. But high-yield credit spreads for issuers have remained relatively tight to investment grade. Distress ratios currently indicate high-yield default rates of just 3.6 per cent in the US and 2.2 per cent in Europe by the third quarter 2024, Deutsche estimates; its forecasts call for 8.4 per cent and 4.4 per cent respectively.
And for high-yield distressed debt, it’s all about the real estate:
This year’s study finds that all grades can probably be trusted to outperform government bonds over the long term, though single-B and CCC will be in trouble if the base case for defaults proves optimistic. The problem is the short term, says Deutsche; because in a recession, there are plenty of ways for stuff to get a lot cheaper.