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EVEN IN RECESSION, DEFAULTS WILL BE LOWER THAN PREVIOUS CYCLES

George Curtis

Portfolio Management

Meet George

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TwentyFour Blog
| Read | 3 min
16 May 2022

Corporate default rates across Europe and the US remain near record lows, with
the European high yield 12-month default rate at just 0.1% on a notional basis
as of the end of April and the US equivalent at just 0.5%, according to
CreditSights research. While default rates are by their very nature
backwards-looking, there are a number of reasons why we believe they will remain
low even if we do dip into recession, a possibility which is of course being
talked about with increasing frequency at the moment.

Firstly, corporate balance sheets have strengthened significantly since 2020 and
entered 2022 in a position of real strength; cash as a percentage of EBITDA was
at all-time highs and median net leverage across Europe and the US was at its
lowest level since the financial crisis, according to Goldman Sachs research. In
addition to balance sheet strength, the vast majority of the high yield universe
used the attractive funding conditions last year to term out their maturity
profiles. In fact, 2022 maturities in both US and European high yield equated to
just 1% of their respective indices. Even 2023 maturities remain subdued, with
the bulk of the “maturity walls” coming in 2025 or later.

Secondly, consumer balance sheets are also at multi-decade strengths given COVID
related fiscal stimulus packages that led to large increases in consumer
savings. While we have seen savings rates decline this year, the large amount of
savings stock that consumers have built up over the last few years helps to
provide a buffer against the economic volatility and cost-of-living squeeze that
we are currently seeing. 

Thirdly, previous recessions, particularly in the US, have been characterised by
very large defaults in the oil and gas sector. Given where energy prices have
spiked to in recent months, energy firms are posting record levels of earnings
(the European energy sector collectively posted year-on-year earnings growth of
over 200% in Q1 2022), and the capital allocation priorities of lower rated oil
and gas companies in the US have become more rational over the last five years.

Fourthly, we have just gone through a default cycle, so the weakest names within
the high yield universe have generally left the market or reworked their capital
structures. The US high yield energy default rate reached almost 30% in 2020,
for example, while the European high yield’s usual trouble spot (retail) also
saw multiple restructurings that year. 

In addition to this, sponsors were generally very supportive of their portfolio
companies throughout the crisis, injecting cash when needed or providing credit
lines. Higher levels of ‘cash equity’ heavily incentivise sponsors to continue
to support their portfolio companies through another (less severe) downturn in
order to ultimately realise their investment. 

Lastly, it is worth pointing out that throughout the recent spread sell-off, the
distress ratio in high yield has not spiked materially higher. The distress
ratio is the percentage of the index that trades above 1000bp, and is often a
useful indicator of future defaults. The current level of 3.2% in European high
yield compares to highs of 14% and 9% in 2016 and 2018, respectively. 

Now, it is worth highlighting that we do of course expect the default rate to
rise. The ultra-low levels we are seeing at the moment are unsustainable in an
environment of slowing growth and persistently high inflation, particularly if
we go into a recession. The early estimates for default rates in 2023 validate
this, with the likes of JP Morgan expecting 2023 defaults of 2.25% in Europe and
1.25% in the US.

With recessionary fears building, we think it prudent to continue moving up the
ratings curve to increase overall credit quality.
We do however believe that the default rate will remain low relative to previous
cycles (that US estimate from JP Morgan is some 175bp below the longer term
average), and will be primarily localised to companies that have very high
levels of energy intensity, limited pricing power, or large exposures to
Russia/Ukraine.
 



 


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