Why we believe default rates will be lower this cycle

In his heyday, Michael Milken was known as the ‘King of Junk Bonds’. His sobriquet reflected the risky leverage characteristics of the nascent 1980s high yield (HY) bond market, and Milken’s position atop it.

How times change.

By 1990 the king had lost his crown, with Milken agreeing to a lifetime ban from any involvement in the securities industry.

Junk bonds ain’t what they used to be

HY bonds also aren’t what they once were. If Milken were running his emporium today, he’d likely be known instead as the ‘Lord of Loans’.

The risky leverage characteristics of the junk bond market have been diluted over the past decade, which we believe could have a profound impact on the default rate as the US economy faces a likely recession in 2023.

Before examining the composition of the HY market, let’s consider what sort of recession we might face next year.

A different kind of slowdown

Each slowdown is different, and the Global Financial Crisis (GFC) was likely the worst we’ll see for a while, not least because afterwards the balance sheets of the banks improved beyond measure.

2023’s cyclical slowdown is likely to be a very different beast, and one central banks appear confident they can tame. One of the features that makes the 2023 slowdown different from previous ones is that it’s rare for a slowdown to be so widely foreseen.

This should allow preparation, which is one of the reasons we expect the recession to have a comparatively mild impact on leveraged entities.

Credit quality compared

Not only will the challenges of 2023 likely be more modest than those faced in the GFC, but the new makeup of the leveraged bond market should also mitigate against widespread defaults.

Since the GFC credit quality in HY has improved dramatically. In the US HY market, comparatively highly rated BBs represented 46% of the market in December 2007, rising to 58% in October 2022.¹

Lower-rated CCCs, meanwhile, have almost halved over the same timeframe, falling from 17% of the market total to just 9%.²

Outside the US, BBs have also been growing as a proportion of the market, while CCCs have declined somewhat. BBs rose from 47% of the European HY market in December 2007 to over 70% in October 2022. Over the same period, CCs fell from 8% to 6%.³

In emerging markets, BBs already represented 60% of the market in December 2007, rising to 71% by October 2022. CCCs have risen from 2% to 8%⁴, remaining a relatively small slice of the total.

The default position

The point to note here is that CCCs have by far the highest default rate (DR).

In US HY during 2009 the DR for CCCs was 27%, for Bs it was 7% and for BBs it was 2%.⁵ The outcome of the DR and the composition of the HY market at the time was an overall DR of 9.56%.⁶

If we apply the same DRs to today’s benchmark we arrive at an overall DR of 6.54%. Given the predominance of BBs in Europe and EMs – combined with our expectation that this slowdown will not be comparable with the GFC – we believe the global DR will be around half that seen in 2009, and much less than the double-digit rate some are projecting.

Where did the risky credit go?

So, where have all the CCCs gone? One explanation is that leveraged buyout funding has been subsumed into the leveraged loan market, unlike in 2008 when it formed part of the HY market.

Additionally, the advent of private credit has reduced HY B issuance and has taken a lot of lower-rated risk off the banks’ balance sheets, which is beneficial from a systemic risk point of view.

As such, the next wave of material defaults will, we believe, likely occur in the private credit and leveraged loans markets. However, if the recession proves mild that default wave may not hit this time around.

 

1. Source: ICE BofA Global High Yield Index, as at 31 October 2022

2. Source: ibid.

3. Source: ibid.

4. Source: ibid.

5. Source: Moody’s, as at 31 October 2022

6. Source: ibid for DR, using ICE BofA Global High Yield Index