Research report

The implications of a rising default rate

Many cite the coming wave of defaults as cause for concern, but history tells us otherwise

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September 15, 2020 | 6 minute read

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.

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.

Robert Hoffman, CFA

Managing Director, Credit Wealth Solutions

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