Investors that lend to U.S. junk-rated companies aren’t being compensated for the looming credit shakeout that could push defaults to record highs, according to UBS Group AG credit strategists Matthew Mish and Stephen Caprio.
"There is a bubble in speculative grade credit," Mish and Caprio wrote in an April 11 note. "Simply put, clients were not being compensated for the credit risk."
A slowdown in U.S. growth could cause the bubble to pop, stressing the lower-quality companies that constitute almost half of the universe of speculative-grade bonds and loans. Investors that crowded into the debt could suffer massive losses, Caprio said in a phone interview. The same strategists put the probability of a U.S. recession this year at 23 percent, according to a March 3 note.
"We believe roughly 40% of all issuers are of the lowest quality, and roughly $1 trillion which will end up 'distressed debt' in this cycle," Mish wrote. "Much of the debt was bought to pick-up yield linearly, but the default risk is exponential."
Even as credit spreads tightened in the second half of the year, recovery rates — or how much of their principal investors get back when there’s a default — have slipped, JPMorgan Chase & Co. strategists led by Peter Acciavatti wrote in a March 31 note. The measure for high-yield bonds during the last 12 months was 22.8 percent, down from 25.2 percent at the end of last year and well below the 25-year annual average of 41.4 percent, the strategists wrote.
As the bubble bursts, speculative-grade companies could find it even more expensive to borrow. Investors have already grown concerned about weakening credit quality and have started to exercise caution: high-yield issuance is down 53 percent this year and bonds carrying some of the lowest grades, namely CCC ratings, are yielding 15.2 percent, according to UBS, even after a rally during the second half of last quarter.
The recent junk-bond rally ignores what the strategists see as "material" risks in the universe of high-yield bonds and loans, which they say is more leveraged than it was in the late 1990s.
"This leaves firms more vulnerable to peaking profit margins, rising interest costs, tighter capital markets and a slowdown in U.S. growth," the strategists wrote.
Many companies that should’ve imploded during the financial crisis are still afloat, they wrote, thanks to easy central-bank policies that limited credit losses, reduced borrowing costs and encouraged investors to put their money in riskier assets to get yield.
The credit explosion isn’t worrying the bulls because they believe economic growth will keep pace and U.S. corporate profit margins won’t decline too much.
"We think the outlook for global growth is positive over the next 18 months," said Henry Peabody, who helps manage the Eaton Vance Bond Fund in Boston. "The market isn’t screaming cheap — you have to be pretty selective — but it’s by no means scary to us."
UBS says investors aren’t prepared for the risk of a slowdown in U.S. growth or the risk that profit margins will fall. Either scenario could cause the current credit bubble to pop, stressing the lower-quality companies that constitute almost half of the universe of speculative-grade bonds and loans and the investors that crowded into the debt.
Credit has rallied but it still isn’t yielding enough, UBS says. Adjusting for losses that would occur if the default rate got as high as it typically has during recessions, almost half of all speculative-grade debt would yield less than zero.
Global defaults are on track to rise above their long-term average for the first time since August 2010, according to Moody’s Investors Service. The rating firm sees the global speculative default rate increasing to 4.3 percent in the second quarter, from the current level of 3.8 percent.
If Mish and Caprio are correct, quality deterioration and market illiquidity could push speculative-grade default rates to a record when the bubble bursts, and spreads on the debt could widen to 16.4 percent, more than double what the bonds now yield over U.S. Treasuries. The trailing 12-month default rate in the U.S. right now is 4.1 percent, Caprio said.
"Investors were herded into lower-quality credit risk for a yield pick-up of a couple hundred basis points," they wrote. "But the fundamental problem is that the default risk is exponential, not linear in these securities."
UBS said it is "structurally bearish" on corporate credit and favors higher-quality assets.
The bubble may not burst this month, but when it does, it will create "a lot of losses for everyone who’s crowded into corporate credit," Caprio said. That could cause credit conditions to tighten, shutting even higher-quality issuers off from the market.
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