Deutsche Bank Says World “Past the Point Of No Return” In The Default Cycle

(April 11, 2016 - by Tyler Durden)

Tyler Durden:  Over the past year, the credit cycle finally turned, and has unleashed the latest default cycle. In fact, as BofA’s Michael Contopoulos warned last week, it may be the worst default cycle in history with “cumulative losses over the length of the entire cycle could be worse than we’ve ever seen before.”

Over the weekend, the FT got the memo with a report that “global company bond defaults at highest level since 2009” in which it said that “the global bond default rate by companies is running at its highest since 2009 with the US accounting for the vast majority, according to rating agency Standard & Poor’s. A further four defaults this week, with three coming from the troubled oil and gas sector, pushed the overall tally to 40 with a little over a quarter of 2016 done.”

To be sure, the US default cycle is bad and getting worse. But how much worse?

The latest to attempt that answer is DB’s Jim Reid who in his just released 18th annual default study explains why his “late cycle fears continue to build.” These are some of the highlights:

There are clear signs the cycle is turning, especially in the US. Our US strategists have previously suggested that we need the combination of three conditions for us to be confident the next default cycle is imminent. We need the accumulation of excessive debt and preferably of deteriorating quality, some kind of external shock/trigger and tighter monetary policy/a flattening of the yield curve. The pieces of the jigsaw are building. US corporate debt accumulation now compares with that seen prior to previous default cycles. Equity volatility has seen two spikes in the last 12 months (August and early 2016), bank equity is falling (a lead indicator of lending?) and global yield curves continue to flatten.

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The buildup of excess is often a pre-requisite for bubbles to burst or for economic cycles to be vulnerable to shocks. One argument for why this US economic cycle might still be able to run for a few years is that many economists feel that excess hasn’t been as prevalent as in prior cycles. However one can argue there has been a sizeable increase in US corporate debt since the GFC comparable to increases prior to previous default cycles. As Figure 15 shows, in the modern era of leveraged finance the debt cycle waves have been well correlated to defaults. We’ve used single-Bs to keep credit quality constant throughout and used Fed data to determine non-financial corporate debt/GDP.

Our US credit strategists measure the total growth of debt stock as well as its aggressiveness to determine whether there has been sufficient “material” created to feed the next wave of defaults. Figure 16 looks at the growth of the stock of US HY debt as well as the aggressiveness of new issuance. The former is measured by the combined size of the HY bond market (USD developed markets) and loans on U.S. bank balance sheets. The graph shows distinct periods of debt growth in the past, going back to the late 1980s, with each of the past three complete credit cycles preceded by waves of new debt creation, lasting from four to five and a half years, and resulting in cumulative debt stock growth of 53-68% (shaded areas). The current episode, measured since early 2011, has lasted 5.2 years and resulted in 64% growth in the combined value of the high yield bond market and loans on bank balance sheets, putting it comfortably inside the range of previous cycles. It shows a similar result to our own US corporate debt/GDP chart.

For a measure of aggressiveness in recent issuance trends, our US strategists look at CCC-rated issuance in HY and leveraged loans, as a percentage of total market size, as shown in the right-hand graph of Figure 16. Volume is presented as a percentage of total market size (HY + loans), on a trailing-12- month basis. Shaded areas again highlight previous debt growth cycles, as well as the most recent one, with figures printed inside representing cumulative CCC issuance volume for the full duration of each episode, divided by the market size at its start. The previous two credit cycles, in the late 1990s and mid- to late 2000s, saw this indicator expand by 20% and 18%, respectively, compared to its present value of 17%. Unfortunately, there is a lack of detailed issuance data to extend this to the first cycle in the late 1980s.

The analysis is somewhat conservative in estimating the starting point of the current credit cycle to be January 2011. Arguably, the market was healing and perhaps even expanding in 2010, which would make these measurements of pre-requisite debt growth and aggressiveness look even more stretched here. We will nonetheless use the numbers shown above, as we aim to build our case for the timing of the next default cycle based on the more conservative assumptions.

We can therefore conclude that pre-requisites for the next default cycle are now in place.

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