Investors Brace for Defaults as Distressed Debt Swamps Market

  • Market measures imply a default rate of as much as 4.8 percent
  • A distressed debt ratio hasn't been this high since 2011

Junk-bond investors are bracing for a surge in corporate defaults that would exceed the most pessimistic forecast from credit raters as the Federal Reserve contemplates its first interest-rate increase since 2006.

A measure of distress in the market is suggesting investors have priced in a
default rate of 4.8 percent during the next 12 months, according to Martin Fridson, a money manager at Lehmann Livian Fridson Advisors LLC. That’s almost two percentage points higher than the pace being projected for June next year by Standard & Poor’s, the world’s biggest credit rater, as concern mounts that energy companies that loaded up on cheap debt are going to struggle to refinance.

“Unless there is a miraculous turnaround in oil prices there is likely to be a lot of defaults,” Fridson said. “The rating agencies’ approach isn’t capturing the fact that a large part of the economy is far out of step with the overall picture of the market.”

The last time junk-bond investors had priced in so many defaults, it was 2011. The United States had just lost its AAA credit rating, Europe’s fiscal crisis was threatening to infect markets globally, and central banks around the world would soon begin pumping unprecedented amounts of cash into the financial system.

As that largesse pushed borrowing costs to record lows, energy companies in the middle of a shale boom in the U.S. tapped into the cheap debt to fund their drilling operations. Oil and gas drillers issued $213 billion of junk-rated bonds the past four years, increasing the share of energy-company debt in a Bank of America Merrill Lynch index of junk bonds to 13 percent this year from 9.4 percent in 2005.

"The high-yield market has become very bifurcated -- worries about commodities are the overarching theme," said John McClain, a money manager at Diamond Hill Capital Management Inc. in Columbus, Ohio, which oversees $16.6 billion.

With oil now at around $44 a barrel, or about 60 percent below its 2014 peak, investors are demanding more yield to own debt of commodity-related companies. That’s pushed the share of the speculative-grade bond market that’s considered distressed to 15.5 percent, the highest since 2011, S&P analysts led by Diane Vazza wrote in a report Aug. 27.

"It’s a vulnerability indicator," Vazza said in an interview. "Those issuers are most at risk and may have difficulty with their interest payments or rolling over debt."

Oil and gas company debt comprised more than a third of the $128 billion of securities trading at levels considered distressed in August, according to S&P. At the same time, half of the debt issued by speculative-grade metals, mining and steel companies were distressed last month.

Unlike 2011, though, borrowers are facing a Fed that’s been winding down its stimulus measures and is considering an increase in interest rates from the near-zero level since 2008.

Edward Altman, the New York University professor who developed the Z-Score method for predicting bankruptcies, says defaults will breach the historical high next year and the Fed is the "wild card" that has the power to determine how quickly the current credit cycle ends.

“We’re somewhere in the eighth inning of a nine inning game, but the score is tied so there’s a chance for extra innings,” Altman told a group of investors and analysts at an event hosted by the New York Society of Security Analysts last week.

Altman, who last predicted the end of a benign credit cycle in January 2007, expects the default rate will reach 3.25 percent by the end of this year as a greater percentage of high-yield debt issuance comes from the riskiest companies.

"A lot of bad news has been priced in," Diamond Hill’s McClain said. "We still remain fairly pessimistic."

Before it's here, it's on the Bloomberg Terminal. LEARN MORE