“Even a dead cat will bounce if it falls from a great height.”
Old Wall Street saying
After every market collapse traders fret about getting sucker-punched by a relief rally that subsequently reverses itself – a “dead cat bounce” in the markets’ parlance. Credit markets, although bolstered thus far by a panoply of direct and indirect government support efforts, remain vulnerable to just this sort of nasty whipsaw.
Counting on a series of fortunate events
A sequence of related events will be needed to extend the rally in credit spreads: government support programs must continue, and be more effective than they’ve been to date; we avoid further waves of Covid-19 infections; consumer spending quickly returns to its former level, driving a rapid economic rebound; and the corporate default rate only rises moderately and then retreats quickly. As we explain later, the current relationship between credit spreads and defaults underlines the market’s vulnerability to a reversal.
The last time spreads blew out and recovered was during and after the financial crisis. Then, the spread rally was large and long-lasting, and reflected a somewhat analogous series of developments. This time around the economic damage is arguably more severe, although on the positive side the economy isn’t beset by the same sorts of imbalances as in 2007. But in other regards the way forward is less certain, mainly because the downturn reflects an unprecedented public health crisis. And this is before considering the economic impact of the on-going civil disturbances wracking American cities. All in all, I think it takes an optimist to assume that history will repeat itself in a good way, and that the credit markets will continue to prosper.
High yield spreads: there’s a lot of good news priced in
It’s worth recalling that the credit markets, like equities, have come a long way in a hurry. Since peaking in the third week of March, the average high yield credit spread has recovered to the point that it is now only modestly above its long-term average. Spreads are also well under the pre-pandemic high tick reached in 2016, when economic conditions were much more favorable than today (Figure 1).
Figure 1: Average high yield credit spread (through June 1, 2020)
The market rebound is all the more striking in light of the gap between what fund managers are saying and what they are doing. Only 10% of institutional investors believe that we will get a V-shaped recovery, i.e., a rapid bounce back that would underpin a quick a recovery of corporate profitability and growth that would be consistent with rising equity and bond prices. So if the vast majority of fund managers have bearish outlooks, why are the markets going up? One reason, particularly in fixed income, is that it’s always a good idea to “buy what the Fed is buying”. But the bank can only support asset prices for so long; if recovery turns out to be L, U or W shaped, i.e., prolonged and halting, then the rate of bankruptcies is likely to go up and stay up, depressing bond values. The only explanation that makes sense to me is that asset managers have a strong belief that the government’s support for the markets, the economy, and individuals will continue, and that it will prove to be effective in restoring growth.
Credit spreads and default rates: compare with care
As described in an earlier post, a bond’s credit spread is the extra yield that investors demand for taking on the risks inherent in owning a corporate bond instead of a risk-free government security. Chief amongst these risks, particularly for high yield issuers (companies rated BB+/Ba1 and below) is that of issuer default. Other factors include the risks of lower liquidity and increased supply. When credit spreads rise yields go up as well (absent a powerful countermove in government securities), and bond prices fall.
Since default risk is a key driver of credit spreads, logic suggests that spreads should be greater than default rates: otherwise, the extra yield spreads represent would be consumed by losses in the bonds’ values when the issuers stop paying interest and principal. This is true most of the time, as we discuss below. Readers should also recall that in most cases when bonds default investors don’t lose all of their value, so the write-off is significantly less than would be suggested by the default rate.
It generally doesn’t make sense to compare credit spreads and default rates, since they are two very different measures. Like all market price-related metrics, credit spreads are forward-looking. If investors anticipate better economic conditions (and thus a lower default rate) in the months to come, spreads will reflect that today. By contrast, default rates are cumulative counts of past events. Reflecting this, during the financial crisis the average high yield spread peaked in December 2008 while the trailing 12-month default rate topped out later in 2009. Back then the market’s expectation of a rapid fall in the default rate proved to be correct and the spread rally continued for another two years. Any fears investors had of falling felines were not borne out.
Despite their different calculation bases we can still gain insights from a comparison of the two metrics. This is particularly so in periods when the default rate is stable, which makes the timing differences embedded in the measures less significant.
Figure 2 shows the single-B one-year default rate and credit spread since 1997. Default rates are updated monthly, but here we just show them for January to December of each year. The credit spread is the average for each calendar period. From 2011 onward, a stretch when the default rate was mostly stable at a low level, the average gap between the two time series was 391 bp. The standard deviation of the gap was 117 bp.
Figure 2: Average single-B spread p.a. and 1-year default rate
It’s going to get worse before it gets better
Returning to the present, on June 1 the average high yield spread was 643 bp. Moody’s 12-month default rate through April, the latest available, was 4.6%, or around 180 bp less than the spread level and well under the recent average differential. The cumulative default rate through May will almost certainly be higher.
Consistent with this, Moody’s projects a default rate of 10% to 19% in the coming months, while the corresponding outlook from S&P is for an increase to 10% to 13%. Forecasts can be wrong, of course. But this caveat aside, two things have to happen to avoid a significant spread rise that will be needed to compensate bondholders for greater credit losses: the realized default rate ends up at the lower end of the agencies’ projections, and that it retreats swiftly from its peak level.
Companies default for two reasons. One is financial –they cannot roll over their debt in the markets or borrow from banks. The other is operational, meaning that their businesses cease to generate enough cash to pay their obligations. The Fed’s market support programs have significantly reduced the financial risk for high yield issuers, leaving business risk as the main threat to increase the default rate. Thus, limiting a sustained rise in defaults, which the market is not pricing in, comes back to improved business conditions. This in turn depends on the series of fortunate events that I described at the outset.
I wouldn’t go so far as to say that the proverbial sun, moon, and stars have to line up for spreads to rally further from here. But I don’t think we’re far off that.