London (Reuters) – If there really is an economic hurricane coming, the junk bond market should be shaken up.
Last week, Jamie Dimon, the CEO of JPMorgan (NYSE:JPM), worried out loud that even though the sun was still shining in the financial world, “a hurricane is right out there down the road coming our way.”
An economic hurricane can mean different things to different people. Most people think of rising prices, high interest rates on loans, and high unemployment rates. But for businesses and bond investors, a “superstorm” is a rise in default rates and bankruptcies.
Like the stock market, U.S. corporate bonds have had a rough start to the year because of the possibility that the central bank will raise interest rates to stop inflation that has been high for decades. Investment indexes and exchange-traded funds have fallen by 10–15 percent, and borrowing rates have risen after being near record lows for the past two years.
Even so, the yield premium on “junk bonds,” which are the riskier sub-investment grade corporate bonds, over U.S. Treasuries remains below the average spreads of the last 20 years. This is where they’ve been for most of the past decade, if you leave out the three-month pandemic blowout. Over the past 10 years, U.S. trash would have given an average total return of 5% per year.
But if low inflation, low interest rates, and slow growth without a recession explain a lot of this calm, then most investors should be worried that the next 10 years will change all these assumptions.
Even though Dimon warned of a storm, the economists at JPMorgan do not expect a recession in the U.S. next year. Those who do are still in the minority, even though Goldman Sachs (NYSE:GS) chief operating officer David Waldron spoke last week about problems caused by a combination of shocks that has never happened before.
However, Deutsche Bank (ETR: DBKGn) is one of the few that formally predicts that the US economy will contract for two consecutive quarters in the second half of 2023, and its prediction of how this will affect corporate defaults sounds like gale force winds.
Strategists Jim Reid and Karthik Nagalingam say in their annual review of the corporate credit outlook, “The End of the Ultra-Low Default World?” that a recession next year will cause the U.S. junk default rate to rise from its historic low of around 1 percent now to 5 percent by the end of 2023 and then double again to 10.3 percent in 2024.
This double-digit rate of defaults across all high-yield bonds would be the highest since the 2008 financial crisis. It would also be similar to the double-digit default rate peaks that came after recessions in 2001/2002 and the early 1990s.
Chart of the default rate over time from Deutsche Bank: http://fingfx.thomsonreuters.com/gfx/mkt/zjvqkgzznvx/One.PNG
High-yield bond spreads between the US and Europe can be seen here: https://fingfx.thomsonreuters.com/gfx/mkt/myvmnwllxpr/Two.PNG
DOUBLE-DIGIT DEFAULTS
In that case, they think that the spread between junk bonds and treasuries will double to 850 basis points by the end of next year.
The breakdown into sections that go together shows more. Default rates for companies with BB credit ratings, which are just below investment grade, are expected to peak at 2%. But the rate of default for companies with a single B rating could reach 11%, and the rate of default for companies with a very risky CCC rating could reach a huge 45%.
And because BB names have a much higher weighting in European junk bond indexes, default rates there are expected to peak at 6.6% overall.
Based on what has happened in the past, the Deutsche strategists say that the markets are not priced for this scenario. Assuming that 40% of the original investments could be recouped after a default, the high-yield spreads of today would not make up for the six separate default cycles that have happened since the late 1980s.
Their point of view is based on what they call a “tug of war” between rising real yields and term premia and the fact that governments want to hide the “debt super cycle.” But they think that the latter will happen slower than in the past because of persistent inflation problems, and it will only happen in certain places, like the edge of the euro zone.
“This two-way tension, however, means that the two-decade era of low inflation, falling term premiums and real yields, long business cycles, high profit margins, and guaranteed and immediate central bank intervention is probably over,” Reid writes.
And just like Deutsche’s view on defaults is based on predictions of recession and persistent inflation, which are still minority views, many investors’ more laid-back approach to junk bonds is based on their more optimistic view of the background.
Pictet Asset Management’s “Secular Outlook” for global investments for the next five years, which was released this week, dismissed talk of a long-term structural shift in the world economy to a new regime of high inflation and slow growth like the 1970s.
Since economic growth and inflation have returned to the averages of the last 10–15 years, they think that the current macro volatility is temporary, caused by the pandemic and supply shocks, and that the mega trends of savings gluts and slow productivity growth have not changed enough to raise real yields in a sustainable way.
“As long as real interest rates don’t go up by much, I don’t see a structural rise in default rates, “said Luca Paolini, chief strategist at Pictet AM. He added that a more likely problem was the “zombification” of firms that survive on cheap credit.
Some people would rather have a stiff breeze than a hurricane.
It remains to be seen if long-term investment forecasts are better than long-term weather forecasts.
Three.PNG https://fingfx.thomsonreuters.com/gfx/mkt/gkvlgzyyqpb
The author is Reuters News’s editor-at-large for finance and markets. Any thoughts he has here are his own.
(Written by Mike Dolan, who tweets as @reutersMikeD; edited by Mark Potter)
