Decoding default risk: What are credit markets telling us?

While the economic environment is unclear, we believe we can glean valuable insights about credit markets from implied market default rates.

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September 12, 2022 | 10 minute read

Recession fears began as a whisper earlier this year, but quickly turned to a roar following the second consecutive negative quarterly GDP print in the U.S. While technically two quarters of negative economic growth do not indicate a recession—the National Bureau of Economic Research (NBER) defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months—there is little doubt at the headline level, our economy is slowing. For credit investors, this means the potential for a fresh default cycle. Rather than contribute to the will we/won’t we recession echo chamber, in this note, we assess what a potential default cycle could look like, what that may mean for valuations, and offer a framework for credit investors to assess whether they are being adequately compensated for these risks.

Key takeaways

  • With recession fears taking hold, credit investors are weary of potential default scenarios.
  • Using empirical data, we can estimate implied market default rates to ascertain whether credit investors are being adequately compensated for default risk.
  • Historically, markets have overestimated actual credit defaults, meaning investors have received excess compensation for bearing default risk.
  • Given overall market composition and healthy fundamentals, we do not expect credit markets to experience a severe default environment.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Kara O’Halloran, CFA

Director, Investment Research

Robert Hoffman, CFA

Managing Director, Credit Wealth Solutions