“We could now be at a crossroads,” warns Deutsche Bank in its annual default study report. As the ‘artificial bond market’ is exposed and yield curves flatten on Fed rate hikes so carry risk-reward is reduced and default cycles have often been linked to the ebbing and flowing of the YC through time with a fairly long lead/lag. With HY defaults having spent 12 of the last 13 years below their long-term average (with the last 5 years the lowest in modern history), “a perfect default storm could be created for 2018 if the Fed raises rates in 2015.”
Defaults will stay unusually low so long as current artificial conditions continue. However, as Deutshe Bank explains, the benign default environment of the last few years may be about to change…
HY defaults (using Single-Bs as a proxy) have now spent 12 of the last 13 years below their long-term average. The average for the last 12 years is now 1.5% (0.9% excluding 2009) against an average of 4.9% since 1983 (1983-2002 average 6.9%). In recent years we’ve explained this phenomenally low default environment by discussing the increasingly artificial demand for fixed income which has allowed more borrowers to access capital markets at cheaper rates. Although growth is currently low relative to history, funding costs are even lower relative to the past.
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Why does the YC impact the default cycle? Steep YCs tend to create maximum carry conditions which usually lead to net loosening in lending standards and a weakening in issuance quality in capital markets as overconfidence builds. As the YC flattens, carry becomes slowly less compelling and while stretching for yield/risk might actually intensify first, eventually a flat yield curve leaves the weakest entities looking much more vulnerable than they did at the YC’s peak. Bank/investor risk tolerance reduces as the opportunity cost of carry trades increases and the risk-reward falls. This cycle does have a long lag but has been a repetitive feature of modern financial markets.
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As The Telegraph notes, Deutsche Bank’s warnings came as the International Monetary Fund said that the Fed’s first interest rate hike could trigger a “cascade of disruptive adjustment”.
Full article: Deutsche Bank’s Ominous Warning: A “Perfect Storm” Is Coming In 2018 (Zero Hedge)
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