"The Default Cycle Is Now Unavoidable": How The 'Junk' Cancer Spread To The Entire High Yield Space

One week ago we presented a must read report by Ellington Management which explained that the credit cycle is now turning.

As Ellington pointed out, “We believe that we are now at the end of the “over-investment” phase of the corporate credit cycle in the US that has been playing out since the depths of the GFC. This view is supported by a number of telltale signs of a reversal in the credit cycle:

Worsening Fundamentals – Declining corporate prots, record levels of corporate leverage, and an elevated high yield share of total corporate debt issuance

Defaults/Downgrades – Credit rating downgrades at a pace not seen since 2009

Falling Asset Prices – Price deterioration in the lowest quality loans and the most junior CLO tranches

Tightening Lending Standards – Weak investor appetite for new distressed debt issues, declines in CLO and CCC HY bond issuance, and tightening in domestic bank lending standards

Today, the Deutsche Bank credit strategy team led by Oleg Melentyev, in its “Year-Ahead Outlook 2016” report proves beyond a doubt that not only has the credit cycle turned, but that the default cycle is at hand, initially for energy names (“a default cycle in commodity-related areas at this point is unavoidable, and the only real question here is whether it stays contained to those areas or extends itself to other sectors”) and soon for most other sectors.

Here is Melentyev’s unpleasant message for Yellen, who is now about to hike rates and launch a tightening cycle at precisely the time when should be easing further to take away from the pain that will be unleashed by an inevitable junk bond supernova.

The current credit cycle can be described as mature: it’s old enough, at almost five years, and extended itself far enough (55% debt growth) to be falling right in line with three cycles that came before it in the past 30 years. A widely publicized McKinsey1 study earlier this year estimated a total of new debt created since 2007 at $50trln, half of which came from EM and two-thirds from nonfinancial corporate issuers in DM and EM. Our research suggests that global debt growth rates have remained steady as a percentage of global GDP, at 64%.

A large portion of this funding went towards commodity-related projects, particularly in EM. Our own credit indexes also tell us the extent of exposure to commodities, which is roughly 40% in EM world, and close to 25% in DM. This debt was raised at a time when consensus firmly believed in the commodity super-cycle theory, which at this point we know was wrong.This leads us to believe that a default cycle in commodity-related areas at this point is unavoidable, and the only real question here is whether it stays contained to those areas or extends itself to other sectors.

Evidence we are looking at suggests there is a meaningful probability of seeing early stages of the next default cycle developing in non-commodity sectors as well. We have previously presented a set of indicators in the Evolution of the Default Cycle report in early October, suggesting that recent equity volatility spikes and a widening in highest-quality corporate spreads are potential triggers for tightening credit conditions. We further followed up in recent weeks by showing rare trends emerging in HY underperforming both equities and IG as well as CCCs underperforming BBs, both the types of market behavior usually seen around turning points in the cycle.