There will be blood

When he is not regaling us with daily tales of shrubbery thefts, a medley of injuries, golf and some markets, Jim Reid writes Deutsche Bank’s annual Default Study. The 24th one just landed in FT Alphaville’s inbox, and, as ever, it makes for interesting reading.

First of all, it is remarkable just how tranquil a period it has been for corporate debt.

Last year saw one of the lowest junk bond default counts in a decade, and despite the recent market jitters, only 31 companies have defaulted globally this year, the lowest run rate since 2014 according to S&P Global. Even the rolling default rate of uber-junky triple-C rated US companies is the lowest it’s been for nearly four decades, according to Deutsche Bank.

The reality is that aside from a few notably awful spells in the immediate aftermath of the Covid-19 outbreak and the 2008 financial crisis, it’s been a pretty great two decades for corporate debt, with defaults trending lower and lower.

But Reid now sees a regime change lurking.

For most of this study’s history we’ve been convinced the ultra-low default world would hold for as far as the eye can see. However, this year we speculate that things might become more difficult for corporates in the years ahead.

Our view has long been that inflation would rise this decade for structural reasons. The pandemic and the aftermath has accelerated and exaggerated this. We’ve previously been relaxed about higher inflation vis-à-vis defaults as we’ve thought the authorities would still have to heavily rely on financial repression to ensure the mammoth global debt pile could be smoothly financed in such a world.

However, we now think that such a scenario might be more challenging for funding than we’ve believed in years gone by. Although financial repression will likely stay to some degree, policymakers may find it more difficult to pull all the easy policy levers as they’ve done in the last few decades.

As such, we think there’ll be a tug of war between real yields and term premium naturally trending higher (bad for defaults) versus a desire (or need) for the authorities to intervene to prevent the debt super cycle from being exposed (good for defaults). The latter support may be slower to materialise, less aggressive, and more targeted than we’ve been used to if we move to a higher inflation world.

The “good” news is that Reid doesn’t think creditpocalypse is already upon us, as some have fretted. DB forecasts that the overall US junk bond default rate will climb to 5 per cent by the end of 2023 — the year it expects a recession to start — before peaking at 10.3 per cent in 2024.

The default rate for top-tier junk bonds (rated double-Bs) will only peak at 2 per cent, but Deutsche Bank thinks almost half of all triple-C bonds will end up in default.

Defaults will then moderate, but more slowly than has been the norm over the past two decades, and remain elevated at around 4-5 per cent by the end of 2025, DB predicts.

Europe will probably experience a notably less acute default cycle, with the default rate there climbing to 3.8 per cent by the end of 2023, peak at a more sedate 6.6 per cent in 2024 and then drift back to 2-4 per cent.

Defaults in emerging markets, meanwhile, are already on the rise. “Many issuers in the region have been able to pass through rising costs to customers — at least for now — though financing conditions are also tightening,” according to a report from S&P Global Ratings.

There are many reasons why Reid thinks defaults are likely to be structurally higher in the coming era, such as corporate profit margins becoming compressed.

But his central argument is that business cycles will become shorter than more volatile they have been in recent decades, as faster and more entrenched inflation limits how aggressively central banks can react to downturns.

I’ve been on the record as saying that with the debt mountain as it is, the authorities had to almost permanently use financial repression to keep spot real yields negative for the rest of my career. If they turned positive for any length of time, I felt the global debt mountain would be at risk of seeing hard defaults and systemic attacks.

I must admit now inflation is raging, I’m more nervous that there could be periods where the authorities are more powerless when it comes to controlling yields than they have been for the last couple of decades.

. . . If inflation proves stickier over the next decade, then policymakers will have less flexibility to rapidly and aggressively respond to wobbles, crises and recessions. As such, the central bank put may be more difficult to rely on. Business cycles may roll over more frequently than they have over the last few decades, which will likely add to the structural default rate as investors can no longer rely on the authorities in the same way as they have done over the last few decades.