■ The increasingly hawkish stance of monetary policy and heightened market volatility have focused investors on the prospect of a recession in the near term, but as our colleagues have previously discussed, many markets tend to have weak recession forecasting power. Similarly, in previous research, we’ve also shown that despite the USD HY default rate being a poor predictor of recessions, it has been a very accurate “nowcasting” tool, implying that a common shock pushes ﬁrms into default and contracts the economy coincidentally, not sequentially.
■ However, the “nowcasting” power of default rates will probably be diminished in the current cycle, as defaults are unlikely to increase for three reasons, even if a recession materializes. First, there is a high degree of survivorship bias in the USD HY market given how recently the last default cycle took place, helping to increase its overall quality to the highest level on record. Second, increases in the default rate over the last decade have been driven, almost entirely, by commodities-related sectors like Oil & Gas as prices collapsed, but the current backdrop is more supportive for these issuers than at any other time in recent memory. Lastly, while corporate credit quality is likely past its peak, balance sheets nevertheless remain in one of their strongest positions of the past twenty years.
■ Overall, this leaves us comfortable with our view of a benign default picture, even if a mild recession occurs, and we reiterate our forecast of a 1.9% 12-month trailing USD HY default rate for 2022, comfortably below the long-run average of 4%. That said, we fully acknowledge that idiosyncratic default events will likely emerge, but these should be “one-off” stories as opposed to harbingers of a full-blown default cycle.
Why Defaults Won’t Rise, Even If the Economy Slows
The increasingly hawkish stance of monetary policy and other strengthening headwinds to growth have focused investors on the prospect of a recession in the near term, and while an economic contraction is not our economists’ base case, many see the current heightened level of market volatility as one indication of choppy waters ahead. However, as our colleagues have shown, many markets tend to have weak recession forecasting power. This result is broadly in line with our own work on the ability, or rather lack thereof, of USD HY default rates to forecast recessions. Exhibit 1 highlights this by plotting default rates at the trailing 3-, 6- and 12-month intervals overlaid with recession bars. This exhibit implies that a common shock generally pushes ﬁrms into default and contracts the economy coincidentally, not sequentially.
That said, while defaults don’t contain forecasting power for a recession, they do have the ability to “nowcast” one. This information can be useful given the frequency with which default rates are available compared with announcements by the NBER Business Cycle Dating Committee. Exhibit 2 shows the output of a model we’ve previously implemented to calculate the probability that the economy is in recession, conditional on the USD HY 3-month default rate. Details aside (they are available here for those interested), every time there has been more than a one-third chance the economy was in a recession, our model accurately “nowcasted” one, going back to the 1980s. This has been true whether including or excluding commodities-related issuer defaults, as well as the extremely short-lived COVID-19 related recession; the closest we came to a “false” signal was during the commodities rout in 2015/2016. With this high “hit rate” in mind, the takeaway from Exhibit 2 is that it implies we are not in a recession currently.
However, despite the default rate having historically been an accurate tool to assess the likelihood of being in recession, we see three reasons why default rates are unlikely to tick up materially in the next downturn, reducing the information content of our model, if one were to occur within the next 18 months.
First, there is currently a high degree of survivorship bias within the HY market, which has increased its overall quality to the highest on record. Speciﬁcally, the wave of defaults during the COVID-19 induced recession of 2020 provided the catalyst for many of the weakest ﬁrms to opportunistically restructure their debt. Additionally, the equity squeezes of 2021 also enabled other ﬁrms to shore up their balance sheets. The combination of these events led many of the so-called “zombie” ﬁrms to exit the market via bankruptcy, thus limiting the credit (and leverage) excesses in the current market compared with other pre-recessionary periods.
Second, as Exhibit 3 shows, over the last decade increases in the default rate have been driven, almost entirely, by commodities-related sectors like Oil & Gas as prices collapsed. This was true during both the supply-related shock of 2015/2016 and the COVID-19 demand shock. However, the current macro backdrop for commodities is decidedly different. As our commodities analysts have noted, the structurally low levels of cap-ex and heightened geopolitical risks should keep Energy markets supply-constrained, which will, in turn, support prices comfortably above breakevens; an environment that could hardly be classiﬁed as one that poses macro risks to commodity producers in particular. This, alongside a bondholder-friendly stance to capital management, is reﬂected in our overweight sector allocation to HY Energy.
Lastly, while corporate credit quality is likely past its peak, balance sheets remain in one of their strongest positions of the past twenty years. We have usually shown this by either referencing cash on balance sheets or median net leverage, but Exhibit 4 shows yet another measure that highlights their current strength, relative to history: the 10th and 25th percentile rank of interest coverage ratios. From this exhibit we can extrapolate that the entire distribution of interest coverage ratios has shifted higher, implying that even the weakest HY ﬁrms should still have the ability to service obligations over the near term.
Overall, these features leave us comfortable with our view of a benign default picture, even if a mild recession occurs. As such, we reiterate our forecast of a 1.9% 12-trailing USD HY default rate for 2022, comfortably below the long-run average of 4%. That said, we fully acknowledge that idiosyncratic default events will likely emerge, but we see these as more “one-off” stories as opposed to harbingers of a full-blown default cycle.