Recipe for one corporate default cycle:
- Take a generous heaping of market volatility.
- Combine with contagion in investment-grade.
- Add a liberal dose of monetary policy tightening.
- Whip it all together; be careful not to get your fingers burnt.
With the corporate bond market falling out of bed in recent weeks, it's only natural that some analysts are questioning whether the selloff means we are entering the latter stages of the corporate credit cycle, i.e. a pickup in company defaults. The current credit cycle has arguably been extended thanks to years of low interest rates and easy money from the Federal Reserve, allowing companies to sell boatloads of bonds.
While a plethora of ready and willing investors has so far helped stave off defaults, it does set the stage for a potentially painful shakeout if and when this unusually lengthy corporate credit cycle comes to an end.
Deutsche Bank strategists Oleg Melentyev and Daniel Sorid reckon there are three things that need to happen before the cycle evolves and we see a pickup in the corporate default rate. All of those are now in place, meaning we're turning the screws on corporate credit even if we haven't yet turned the corner.
Here's a rundown.
According to the analysts, a reading of 30 points and higher on the Chicago Board Options Exchange's Volatility Index, the VIX, has been reached at the start of each of the last three credit cycles (1989, 1997, and 2007). The VIX is currently hovering around 20, but rose to as high as 50 on Aug. 24, during the worst of the dramatic market selloff, and stayed above the 30 level for much of that month.
While spreads on debt sold by energy companies and junk-rated corporate bonds have borne the brunt of recent credit market pain, there are signs that it is spreading to the investment-grade universe where companies with healthier balance sheets sell their bonds. The Deutsche Bank analysts argue that widening spreads on AA-rated bonds have historically been a good leading indicator of future defaults. Specifically, they note AA spreads tend to reach their cyclical peaks of about 130 to 140 basis points well before high-yield.
Monetary policy tightening:
Deutsche Bank's last ingredient is a tightening of monetary policy. While that may seem far off, especially as the chances of the Federal Reserve this year mounting its first interest rate hike in almost a decade rapidly recede, the analysts note that we have seen some tightening in real market rates. Market-derived real rates — or the difference between two-year nominal yields and break-even inflation from TIPS — are currently hovering around 50 bps, compared with negative 150 basis points in the years immediately following the financial crisis. Back in 2004 and 2005, they note, that same real rate stood at around 100 bps. "Today's monetary policy may not be as easy as it seems on the surface," Melentyev and Sorid conclude.
Of course, the presence of these three requisites does not a default cycle make, according to Deutsche Bank. We can stay in a purgatory of widening spreads and low corporate default rates for some time to come.
... pre-requisites for the next default cycle are now in place. Pre-requisites, by their nature, provide a necessary but insufficient set of conditions for the early stages of a default cycle to develop. The system can remain in this fragile state for long periods of time, absent a trigger that throws it out of balance. A stack of hay is not a fire hazard in and of itself; someone being careless with matches nearby makes it so. A strong enough volatility shock has played the role of trigger in each of the past three credit cycles.
One to watch.