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The corporate sector isn’t the economy. It’s possible that the economy can be brought into a “soft landing†of lower inflation and somewhat lower growth, and many are hoping for that. But it wouldn’t necessarily follow that companies and their investors would get away for free.
What, to start with, would happen to corporate credit? There’s a lot of debt out there, and that has been buoyed by a steady and remarkable decline in the rate of companies defaulting. That lower default rate isn’t due to any great buoyancy or strength in the innovative economy, but it does surely have a lot to do with low interest rates and a policy by central banks to prioritise rescuing lenders and avoiding a solvency crisis when trouble grows. As that environment relied on low inflation, quiescent for four decades, that raises real issues over whether it can carry on.
The publication of the annual study of historic default rates published by the team of Jim Reid at Deutsche Bank AG shows a regular cycle around recessions, with the default rate among speculative debt issues peaking at around 12%. If recession arrives at the end of next year, as predicted by Deutsche Bank’s economists, it projects a peak speculative default rate of about 10% in the US, and significantly lower than that in Europe.
The trend of lower default rates over time grows clearer when each of the last four cycles are compared directly, as Deutsche Bank says. The reckoning after the dot-com bubble burst in 2000 was greater than after the global financial crisis at the end of that decade, which was much greater than the fallout after Covid-19.
Another way to look at this is to compare the ultimate default rates over time for bonds with different ratings. Whether you follow Moody’s Investors Service or Standard & Poor’s, both clearly show that default rates have been far lower since the cycle that started after the bursting of the dot-com bubble.
This was above all about low interest rates, which were held there by central banks in an attempt to keep the economy from crashing altogether. Their policies were also driven in large part by the implicit aim to minimise losses for bond investors, particularly in banks. Credit losses bring with them a far greater systemic risk than losses in an equity portfolio, which is perceived to be higher risk. “Moral hazard,†or the tendency to take on excessive risk when you know someone will rescue you from the consequences of your actions, has increased a notch after one attempt to reverse the trend led to near-disaster with the failure of Lehman Brothers. Rates have stayed low, and credit investors have perceived that they will have central banks on their side. This arguably robs capitalism of the necessary “creative destruction†and makes for a flabbier and less competitive economy. But for those on the right side of the trade, it’s been good. Both default rates and yields on debt have steadily declined, meaning a better deal for credit investors and for companies looking for finance.
The problem with all of this is that it has been built on an edifice of reliably low inflation. What happens next, now that inflation has risen? The evident risk is that the virtuous circle could turn into a vicious one. This is possible because economic players have grown accustomed to the notion of a “put†that will protect them from loss.
—Bloomberg