Markets have recovered in spectacular fashion following the sell-off during the first quarter. Equities eclipsed their previous record high and credit markets are flirting with positive year-to-date returns. The ride back up was relatively smooth, especially in comparison with the thrashing that markets took throughout February and March. However, as the pandemic lingers and the world still faces a great deal of uncertainty, many investors seem to be wondering when (or if) the proverbial other shoe is going to drop. In credit, many cite the coming wave of defaults as cause for concern. We feel differently.
The virtual halt in economic activity this year has all but guaranteed rising default rates in credit markets. The Federal Reserve’s swift, omnipresent actions have undoubtedly been instrumental in staving off a financial crisis, and the combination of direct lending to companies and the purchase of corporate bonds in the secondary market has helped many bond and loan issuers ensure liquidity during this unprecedented time. But virtually no industry or company has been unaffected by the COVID-19 crisis. Defaults have already begun to rise, and we expect to see that trend continue. The default rates for both high yield bonds and senior secured loans have reached 10-year highs, hitting 5.77% and 4.38%, respectively.
Historically, default rates have tended to lag peak credit spreads by roughly one year. Spreads peaked on March 23, meaning if the typical pattern holds, we may see increasing levels of defaults for another 6–8 months. At that time the default rate may begin to fall, but current forecasts for 2021 are still in excess of historical averages.
High yield bond default rates tend to lag peak spreads by roughly one year
Source: ICE BofAML High Yield Index, Bloomberg, J.P. Morgan, as of August 31, 2020.
Key takeaways
- Default rates tend to lag peak spreads by roughly one year, meaning we could see rising default rates in credit for the next six months.
- As a lagging indicator, an increase in defaults does not necessarily mean lower returns.
- The complexities of investing in defaults or distressed investments, and the range of potential outcomes, require experienced managers.
