Stocks ignore defaults, cruising for a bruising

A worrying trend is developing in the corporate bond market: Even with borrowing costs at or near their lowest ever, companies are increasingly unable to pay their debts. There have already been enough defaults around the world this year to suggest that the record set in 2009 might be beaten. And that should ring
alarm bells for traders and investors who continue to push benchmark equity indexes to
record highs.
The number of defaulting corporate borrowers just reached the 100 mark, according to figures compiled by S&P Global Fixed Income Research. That’s almost 50 percent higher than a year ago. Moreover, the tally has only ever been higher at this point in the year once before — in 2009, when the global economic crisis set a record for defaults:
The oil and gas industry is the weakest horse in the glue factory, with S&P calculating that companies from that sector account for about a fifth of what it classifies as distressed borrowers. Looking ahead, S&P is predicting an increase in the U.S. default rate to 5.3 percent by March 2017, up from 3.8 percent in March of this year and 1.8 percent last year. Europe will fare better because of “loose monetary policy,” S&P says, with the default rate ticking up to 2.4 percent by the end of the year, up from 2015’s 2.1 percent failure rate.
As in 2009, companies in the U.S. already lead the way this year (mostly because they are very active users of the capital markets, whereas bank loans dominate the funding landscape in most other countries), contributing more than half of 2016’s nonpayments and restructurings.
But here’s the worrying thing: That 2009 default record was set at a time when borrowing costs were much, much higher than they are now. Yields on the debt of investment-grade U.S. companies in the first half of 2009, for example, were twice as high as they are today:
For high-yield borrowers — who are more likely to default because their creditworthiness is weaker — the gap is even more extreme. Bank of America’s high-yield eurodollar index shows yields swinging between 31 percent and almost 70 percent in the first half of 2009, though in reality the market was all but closed for business at the start of that year. In contrast, the index shows yields peaked at about 6.5 percent in February of this year and have been at about 5.87 percent for the past three months:
Both the S&P 500 Index and the Dow Jones Industrial Average closed at record highs last week. Edward Altman, a finance professor at New York University who specializes in corporate borrowing, reckons equity investors are blind to the risks being signaled in company debt. Default rates and how much money bond investors lose in debt restructurings are both “pointing toward a more stressed situation,” he said in an interview with Financial Sense:
I really don’t think that the stock market is looking at the credit markets in the last few months as they did at the beginning of the year when things really looked grim and I think that’s a mistake because the credit markets are still not strong with respect to the outlook.
Joseph LaVorgna, Deutsche Bank Securities’s chief U.S. economist, is concerned that the Conference Board’s index of leading economic indicators is pointing to a slowdown. “As the chart below illustrates, in the past two business cycles, an outright year-over-year decline in the LEI after a prolonged period of growth has presaged recession,” LaVorgna said in a research report:
The gray lines indicate recessions; the stock market indicates no likelihood of a repeat slump anytime soon. The true health of the global economy, an enigma at the best of times, seems particularly difficult to deduce currently. But you have to wonder whether anyone predicting that corporate defaults would be on track for a record by the midpoint of the year could have twinned that forecast with also foretelling stocks at record highs. Something’s got to give.
—Bloomberg

Mark Gilbert is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was London bureau chief for Bloomberg News and is the author of
“Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable”