- Default rates should remain relatively low in 2020 due to stable credit fundamentals, accommodative monetary policy, strong capital market technicals and a lack of default triggers.
- Despite benign short-term default expectations, downside risks remain. When the next recession hits, the sheer quantity of outstanding corporate debt is likely to lead to meaningful default activity.
- Unlike the last broad-based default cycle during the financial crisis, the next default wave will likely be led by sector-specific challenges coupled with excessively high corporate debt.
- Looking ahead, this relatively benign environment requires stringent investing discipline given potential late-cycle pitfalls.
Rising defaults? Not what it appears.
Typical of late-cycle sentiment, fears of increasing defaults are infiltrating the market. A slight uptick in default rates and distress ratios has spurred further angst. While default rates have increased modestly, it's not necessarily what it appears. In 2019, five large US companies—Pacific Gas & Electric, Weatherford International, EP Energy, Hexion and Windstream—defaulted and contributed significantly to the pickup in the US default rate. However, most of these bonds had been trading at distressed levels for several years. In many ways, the high yield market was purging some of the long-term large levered companies. And while a few more large levered companies could file bankruptcy in 2020, we believe the credit deterioration is already priced into these distressed securities. Further, we do not expect the default rate to increase materially in 2020.
The distress bond ratio has also ticked up slightly. But a small increase in the distress ratio is not a reason to panic. Distress levels remain well below the last peak experienced during the energy crisis in 2016 (Exhibit 1).
Exhibit 1: US distress ratio has increased modestly, but is well below peak levels
Source: Bank of America Merrill Lynch as of November 30, 2019. Distress is defined as bonds with spreads over 1,000 bps.
Absent a near-term recession, which we do not expect, there are few catalysts that could cause a sharp uptick in the default rate over the next 12 months. Headwinds facing a few specific sectors, such as wirelines, healthcare and energy, combined with idiosyncratic situations may result in a few isolated defaults. But in general, the risk of a material pickup in near-term defaults is mitigated by stable credit fundamentals, accommodative monetary policy, strong capital market technicals and a lack of default triggers.
Four factors supporting a benign default outlook
Stable credit fundamentals
The fundamental backdrop for credit market remains solid going into 2020. Although we expect US GDP growth to slow to +1.8% in 2020, we don't see signs of an imminent recession. This view is predicated on a resilient US consumer, but offset by late-cycle concerns that are exacerbated by trade and election uncertainty. Against this uncertainty, we think the Fed will continue to lean on the accommodative side. Earnings have been decent in most sectors and leverage trends have been stable.
Accommodative monetary policy
In addition to supportive economic fundamentals, the current accommodative rate environment is beneficial for issuers as companies are able to lower their interest costs through bond refinancing or floating-rate loan adjustments. This has led to historically strong interest coverage ratios.
Strong capital market technicals
Capital markets are generally wide open to all but the most troubled sectors. Market technicals remain supportive as investors continue to scavenge for yield, which has led to higher demand within leveraged finance markets. As a result, in many cases, stressed companies can tap capital markets to extend near-term maturities and boost liquidity.
Lack of default triggers
Many stressed or distressed companies have looser debt documents that have allowed issuers to prolong otherwise inevitable restructurings. Further preventing or prolonging a default, issuers will likely continue to effectuate out-of-court transactions—equitize holdings, raise new equity, etc.
Default rates remain low, but don't overlook the quantity of defaulting debt
Although we expect default rates in percentage terms to remain relatively low in 2020, the growth in the size of the overall leveraged finance markets in recent years means that the dollar amount of debt that may default in 2020 is still quite sizable. As evidence, defaults on a dollar basis are approaching the bond and loan defaults experienced during the 2015-2016 energy crisis despite the fact that current default rates are much lower (Exhibit 2). The sizable dollar-based defaults, coupled with continued issuer liability management exercises, helps explain why law firms and investment banks that provide restructuring advice have been busier than they've been in years and continue to expect a robust pipeline in 2020 despite subdued default percentages.
While the dollar amount of defaults is nowhere near the financial crisis, the Moody's issuer-weighted default rate of 3.9% as of November 2019 understates the fact that there is almost as much defaulted debt today on a par value basis as in 2016 due to the magnitude of recent bankruptcies. And while recent defaults have involved larger issuers, a small increase in the default rate could translate into a sizable amount of defaults given the quantity of corporate debt today and some sizable remaining levered companies. Though the high yield market size has stayed relatively stagnant in recent years, the loan market has grown by approximately 65% since 2009 with about $1.3 trillion of loans outstanding in 2019. This prolific growth, coupled with aggressive underwriting standards, fewer covenants and mounting leverage, could result in elevated default activity within the loan market once the maturity wall closes in. Nevertheless, as long as economic growth stays positive and corporate earnings remain healthy, we don't believe this will have a material near-term impact on spreads in leveraged finance markets.
Exhibit 2: Trailing cumulative 12-month defaults on a dollar basis versus US issuer default rates
Source: Moody's Investor Services. As of November 30, 2019.
Monitoring secular risks in vulnerable sectors
We are watching certain sectors exhibiting headwinds. Unlike the last broad-based financial crisis, the next default wave is likely to be led by sector-specific challenges coupled with excessively high corporate debt. Sectors exhibiting signs of stress include energy, retailers, wirelines, pharmaceuticals, healthcare and technology.
Energy. Despite crude oil and natural gas prices recovering from the lows in 2016, investor sentiment towards energy-related credits is very weak. Many energy credits with insolvent capital structures that managed to scrape through the 2016 energy crisis are finally running out of liquidity or hitting maturity walls. Investors appear to have little interest in taking equity in the reorganized companies, which has put significant pressure on these issuers' bond and loan prices and severely limited management teams' options in 2019. As a result, in 2020, we expect to see a continuance of the steady wave of defaults experienced in 2019.
Retailers/retail-related. The Amazon effect continues to contaminate business models as department stores, specialty retailers and supermarkets continue to struggle. Other retail-related companies, like leasing companies and retail distribution companies, are also feeling the pain of the broader shift to online shopping. Even ancillary companies with retail-focused distribution are struggling because of distribution channel issues. As a result, we expect to see a steady trickle of defaults in 2020 in the retail sector even though it is a relatively small component of the high-yield universe.
Wirelines. Wirelines have been declining for years as commercial and residential customers shift to wireless communications. While many of these companies have had the luxury of strong cash flow generation in recent years, the secular pressures are finally catching up to the sector, as evidenced by the bankruptcy of Windstream in 2019. We expect a small number of additional restructurings in this sector in 2020, notably Frontier Communications.
Pharmaceuticals. Weakness within this sector is primarily driven by litigation and regulatory risks. Pharmaceutical companies and drug distributors have been under pressure from looming settlements with tort claimants. Further, increasing pressure from policy makers in Washington is resulting in lower generic pharmaceutical pricing. Stress within this sector will likely remain elevated in 2020.
Healthcare. The healthcare sector remains under pressure as surprise billing legislation—a solution aimed to curb unexpected out-of-network charges for consumers—is likely to lead to lower revenue for several healthcare companies. This sector includes a number of private equity companies that have relatively high leverage and are at risk of default.
Technology. The technology sector has been one of the fastest growing sub-segments of the loan market. Private equity has been aggressively financing leveraged buyouts (LBOs) at elevated leverage levels with significant EBITDA addbacks. Given the aggressive capital structures and late-cycle valuation multiples, combined with the fast-changing nature of the technology industry, we believe this is an overlooked sector for future default candidates.
Lower recovery expectations
When the cycle turns, the narrative will inevitably shift to recoveries. While our near-term default outlook is muted, we are concerned about lower recoveries during the next downturn. Given the lack of covenants, as well as the higher amounts of leverage, it's quite possible the market will witness a decline in recoveries. Recent bond and loan recoveries are well below their long-term averages. On a trailing 12-month basis as of November 30, 2019, high yield bonds and loan recoveries were 28.5% and 50.5%, respectively, according to JP Morgan. This is well below the 25-year high yield bond recovery rate of 41.4% and the 21-year recovery rate of 66.4% for first-lien loans. This lower recovery phenomenon is not entirely surprising given the secular forces at play currently, but it's something we will continue to monitor closely as the current economic cycle evolves.
We expect default rates to remain relatively low in 2020 due to stable credit fundamentals, accommodative monetary policy, strong capital market technicals and a lack of default triggers. We are monitoring headwinds within vulnerable sectors, such as energy, retailers, wirelines, pharmaceuticals, healthcare and technology, combined with idiosyncratic situations that may result in a few isolated defaults. And while we generally expect default rates in percentage terms to remain relatively low in 2020, the sheer quanitity of corporate debt translates into more meaningful default activity on a dollar basis. Further, we expect lower recoveries in the next downturn as defaults are driven by more secular forces.
As we look out to the year ahead, we believe this relatively benign environment still requires stringent investing discipline given the potential late-cycle pitfalls. However, this environment presents several opportunities to identify idiosyncratic, alpha-generating investments across the capital structure as we wait for the end of the economic cycle.
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