Capital market players are trying to assess how much longer the good times can roll, considering that America’s expansion is getting long in the tooth, at six years, and that the companion bull market is wobbling from the all-time highs of early 2015 in the face of full valuations (and then there’s China’s economic slowdown, the emerging market woes, and falling oil prices).
For the same reasons, leveraged credit managers are concerned that the current run of below-trend default activity, which stretches nearly six years since the credit crunch crested in December 2009, may be drawing to an end. After all, since the modern era of high-yield finance began in the mid-1980s, the prior low-default periods ran six years, from 1985-1990; eight years, from 1992-1999; and six years, from 2003-2008.
More broadly, the current run of economic growth and stock market increases is getting to the wide end of the historical range.
Since World War II, the average bull market has lasted 8.7 years on average, while economic expansions have run nearly 5.75 years on average.
On the other hand, even if it appears late in the game for the current cycle, many of the prior cycles went into overtime (and sometimes double and triple OT). The longest economic expansion since 1945, for instance, endured for a full decade from 1991-2001, while the longest bull market stretched 12.8 years, from 1988-2001.
Nothing new under the sun
The current benign credit environment will inevitably give way to a default spike. In credit cycles, as in life, there’s a time to dance and a time to mourn. What loan managers are attempting to model is whether defaultageddon will happen sooner or later, and what that means for investment strategies.
Ahead, we discuss when default rates are most likely to push past the historical average of 3.2% – the rate was 1.3% at the end of August – based on conversations with managers, as well as empirical data.
In preview: The consensus is that the run of low defaults is likely to persist through 2016. After that, managers expect default rates to rise. Naturally, though, a hearty contingent of hawks and doves disagree on the specific timing.
Before we dive deeper, there are three points on which most players agree:
- The near-term outlook for loans is mostly sunny. Most managers believe that loan default rates will remain below trend over the next 12 months. According to LCD’s latest quarterly buyside survey, taken in early September, managers on average said the default rate by amount will rise from August’s reading of 1.30% to 1.72% at year-end 2015 and 2.33% by September 2016. Forecasts generally remain sanguine for the following reasons: (1) a dearth of immediate maturities, (2) fat coverage ratios across the leveraged loan issuer base, (3) market distress remains low; and (4) a solid, if unspectacular, economic forecast through the end of next year.
- Loans are more protected than HY: Our colleague Marty Fridson, the dean of HY strategists, suggested in a comment for LCD that the default rate for HY will likely push above the long-term average of 4.5% in 2016 ($ubscriber link). Even if that proves true, the outcome may be different for loans because the Bank of America Merrill Lynch’s HY Master Index’s exposure to energy – the most troubled sector – is far higher than that of loans, at 15% to 4.7%. The reason, managers say, is because O&G financing often takes the form of borrowing-base reserve facilities from banks with the balance financed with bonds; thus these issuers bypass the funded term loan market altogether.
- Exogenous events are a potential accelerant. The past three default spikes were, in part at least, precipitated by disruptive events: the Gulf War of 1991, the terrorist attacks of Sept. 11, 2001, and the Lehman Brothers bankruptcy in September 2008. These events helped bring on the two elements that are critical to elevate bankruptcy rates: (1) economic recession and (2) a liquidity vacuum that pushes up financing costs and leaves distressed issuers without a ready source of capital.
Considering the scenarios
Let us limit the time frames during which default rates push past the historical average:
- Bear case: by year-end 2016
- Base case: 2017
- Bull case: 2018 or beyond
Here’s how managers handicapped these three possibilities in our latest poll.
In order for default rates to surge over the next 15 months, most players say a shock is necessary. Certainly, the list of known geopolitical and economic tinder boxes is formidable, including weakness in China; the always fragile situation in the Middle East; the potential for a further collapse in oil and commodity prices that drives defaults in these sectors higher while setting off a contagion in aligned sectors; Russia/Ukraine; Greece; or a complete meltdown in the already troubled emerging markets, to name just a few obvious situations.
Outside of such a brutal force, however, managers remain constructive on the near-term outlook as the poll results cited above illustrate. By and large they expect defaults to remain at low ebb, and concentrated within the energy and commodities sectors, in addition to a smattering of names that are potential bankruptcy candidates such as Millennium Labs, Caesars Entertainment, Clear Channel, Gymboree, and Weight Watchers.
Base case: 2017
Assuming GDP growth and benign credit conditions persist through 2016, managers generally see the default cycle gearing up by 2017-2018 for the following reasons:
- Risk of recession: The current economic recovery at that point will be pushing the wide end of the historical envelope, suggesting a higher probability of recession. How high is impossible to say, of course. But recoveries always sow the seeds of their own destruction by the forces of leverage creep, excess investment, and overvaluation.
- Effect of risk-retention rules on structured finance: By late 2016, the CLO risk-retention rules will be in full effect. Though CLO formation will persist, participants say, this form of fund raising will be less profitable (and some say less fun) for asset managers. In the likely event that structured finance’s footprint in the loan market shrinks, players say, the cost of financing for loan issuers will increase as managers rely on less geared products such as separately managed accounts and mutual funds. As well, the amount of loan capacity could well shrink as leverage drains from the system.
- Increase in maturity wall: The amount of loans due starts to rise markedly in 2017, as this chart shows.
Though loans rarely go to term, some issuers could find it more difficult to refinance debt ahead of maturity given the combinations of potentially slowing economic growth – or an outright recession – and the scaled back participation of CLO vehicles. At the very least, financing may well be more expensive, putting pressure on today’s vaulted coverage ratios.
Bull case: 2018 and beyond
There are few intrepid optimists that see a benign credit cycle extending for another three years (or perhaps more). A lot would have to go right for them to be correct. First and foremost, the economy would have to avoid a recession. That is hardly a given, but if so, the bull brief has three main legs:
- Regulation: The regulatory environment has, clearly, reined in more ambitious credit structures for newly minted deals and slowed the recap parade that allowed PE firms to releverage performing properties via recaps. As a result, coverage ratios have remained wide across the leveraged loan universe, affording issuers more cushion against economic setback – with the clear exception so far of the commodities space.
- Fed accommodation: The central bank has been a clear source of liquidity to the system, and many players don’t see the Fed taking away the punch bowl – at most, they think the Fed might spike it a little less. If so, borrowing costs may remain low in the foreseeable future, propping up coverage ratios and providing issuers with refinancing options in the capital markets, even if the loan market capacity shrinks in the teeth of risk-retention rules.
- The reset thesis: Under this thesis, the current market correction doesn’t date from 2009, but really from 2012, when liquidity finally returned to the system allowing new transaction volume to flourish. This chart, which tracks the volume of non-refinancing loans, illustrates the point. If so, the current cycle isn’t six going on seven, but four going on five, suggesting it may have longer to go before it dies of natural, or exogenous, causes.
In the end, default rates will start their inexorable rise to above-trend levels when the market experiences the usual knockout combination of recession and liquidity deprivation. From today’s vantage point, 2017 is the consensus estimate, though that view will obviously shift in either direction as new information comes to light or new crises emerge that threaten global economic growth. – Steve Miller