“A default wave is imminent.”
So said Deutsche Bank’s Jim Reid in the 2023 vintage of the bank’s annual default study, published Wednesday.
For context, last year’s edition suggested a two-decade stretch of suppressed defaults was poised to end amid elevated inflation and policymakers’ efforts to combat it with higher rates which would be foisted upon levered corporate borrowers. Fast forward a year, and the moment is close at hand, or at least according to Reid’s “trusted cycle indicators.”
Credit losses, he said, will rise “consistently” this year, before accelerating in 2024 when the US is expected to enter a recession. Apparently, the bank’s clients are too sanguine about the situation. Reid thinks they’ll be “surprised” by the scope of forthcoming defaults.
Notwithstanding the length of the study (some 40 pages), the thesis is quite straightforward. “The tightest Fed and ECB policy in 15 years is running into elevated corporate leverage built upon stretched profit margins,” Reid said, calling the situation “especially” acute in leveraged loans, and noting that while policy support during COVID afforded companies an opportunity to term out their debt, speculative-grade maturity walls looking out over the next two to three years are the highest since 2015.
As you can see from the visuals, Deutsche expects defaults to peak in Q4 of next year at 9% for US high yield, more than 11% for US loans and nearly 6% for speculative-grade debt in Europe.
Once I’ve had a chance to digest (or at least skim) the full piece, I’m sure I’ll find other interesting points worth highlighting, but on the quickest of quick reads, three key takeaways are i) Reid’s warning on the limits of central bank intervention during the next default cycle, ii) the problem with the termed out maturity wall narrative and iii) the notion that credit markets will fare worse than the real economy.
Below find three very short excerpts from Reid’s tome touching on those three key points.
- Investors may be disappointed by the lack of central bank policy support they receive in the next recession. Inflation that remains above 2% will raise the bar for future QE, while large fiscal deficits will increase sovereign term premia, both combining to keep corporate financing costs higher than expected through a downturn.
- For much of the past two years, a narrative has formed that termed out maturity walls, due to excessively easy financial conditions post-COVID, will shield high yield bond and leveraged loan issuers from an increase in downgrades and defaults. [We have] two concerns with this thesis. First, maturity walls are not the primary driver of defaults; unsustainable capital structures are. 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. [T]he result [is] that the maturity wall for spec-grade issuers at risk of default (sub BB rated HY bonds + leveraged loans) are at eight-year highs.
- We suspect the next recession will be the first since the US tech bubble to inflict more pain on credit markets than the real economy. 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 labor costs are likely to remain sticky because of a shrinking working-age population and a desire for consumers to recoup nearly two years of negative real wage growth. This scenario will 1) pressure profit margins and 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.
Actually, this seems to be a plausible forecast. I’ll look forward to your take in a deeper dive. The excess corporate borrowing to fund stock buybacks has created some very weak capital structures, thus far mostly ignored by the street. My bellcow is KMB which has been carrying a high credit rating with negative net worth for nearly a decade. I’ve got the stock for dividends but I have been donating it because it will suffer. If I were a CFO I be selling stock to lower my leverage if it was above normal. Firms with three or four times debt/equity ratios may look good enough but they are not if operating leverage attacks profits in a even a moderate downturn. Labor costs have risen in many areas and though layoffs cut costs, they also cut output capacity in the long run.