Note that the 53% cumulative default rate for junk bonds over the next five years foreseen by Deutsche Bank analyst Jim Reid is nearly twice the level forecast by Moodys of 29%, It is also well in excess of the rate during the S&L crisis, which produced a nasty but comparatively short recession.
From Bloomberg:
About 53 percent of U.S. companies that issued high-risk, high-yield bonds will default over the next five years, according to Jim Reid at Deutsche Bank AG.
The figure compares with a 31 percent five-year rate in the early 1990s and 2000s, and as much as 45 percent “in a very, very different market in the Great Depression,” Reid, the London-based head of fundamental credit strategy, wrote in a note to clients today. The estimate is based on the premium investors demand to hold the notes and assumes recoveries from the defaults will be zero, Reid wrote.
Yves here. No recoveries would seem to be an awfully aggressive assumption, but we have noted that the widespread use of “cov lite” loans means a much higher proportion of companies will enter bankruptcy in a much weaker condition than in past downturns (covenants enable lenders to force restructurings earlier in the process, when there is more to salvage). Thus a higher proportion will wind up liquidating. However, note that the recovery assumption is independent of the default rate estimate. Back to the article:
“Given that this recession will easily outstrip the 90s and 00s, then 40 percent high-yield defaults over five years seems to be a minimum starting point for this default cycle,” he wrote. A 50 percent rate is “not unrealistic.”…
According to Moody’s Investors Service, the 12-month default rate will rise to 22.5 percent in Europe and 13.8 percent in the U.S. by the end of the year, the New York-based firm said in a report last month.
Moody’s expects the five-year default rate to be about 29 percent by February 2014, according to the report.
“The main catalyst for this crisis, namely property, is still vulnerable around the world,” Reid wrote. U.S. real estate prices still have more than 16 percent to decline, while the figure is almost double that in the U.K., Reid wrote
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There will be a lot of junk bonds with zero recoveries due to companies highly levered with senior and junior secured lenders, with pledges that cover almost all assets.
"Note that the 53% cumulative default rate for junk bonds over the next five years foreseen by Deutsche Bank analyst Jim Reid is nearly twice the level forecast by Moodys of 29%"
>>Yves,
It all boils down to how deep this recession will be. If U.S. unemployment peaks at 12% or 15% or worse, then the Deutsche analyst is right.
If, however, the worst is behind and unemployment peaks at 10% or below, then the Moodys analyst is right.
Either way, high yield debt will get crushed in the next three to five years.
cheers,
Leo
Leo,
In the last cycle, many companies had more leverage through secured debt and less through unsecured junk. This fact will make junk bonds do worse in many companies. A lot of people bought junk bonds without thinking how much further back in the bus they are in this cycle.
I expect it to be snowing and 25°F on November 17, 2012 with a study ENE breeze of 7mph.
I’m close to having an understanding of intuition as it relates to implied default rates given current spreads under average and zero recoveries…Any help?
Yves,
These kind of soundbites are what I am afraid of. It is not coincidence Jim Reid specifies the next 5 years.
The entire Merger and Acquisition mania of 2004-2007 was largely financed with Collateralized Loan Obligations. From my understanding, these are term loans with long fuses, typically 5 years. These five year fuses will be blowing up should be particularly acute between 2009-2012.
Its not just CRE and underfunded pensions that overpromised as the next pair of shoes that have to drop. So, when I hear Roubini talking this past week that he thinks the worst might be over, I wonder what he has been smoking.
Granted, peak job losses may have transpired with the revised Jan 09 and Dec 08 NFP numbers. And it may be one thing for Bernanke and other spinmeisters to speak of “green shoots” of recovery based on anecdotal seasonally adjusted Feb economic numbers, but I am surprised to see the shift in Roubini.
Back to my point, CREs and CLOs are next to be tossed on the dung heap of toxic waste/assets. And how are we going to finance the underfunded pension gaps both private and public? No doubt, underfunded private pension funds can contribute to the corp junk bond defaults Reid sees coming down the pike.
@ Leo
What’s there to stop unemployment reaching 30% or more?
Does America have a God given right to have unemployment less than 15%?
Where are the trillions and trillions required to finance the budget deficits going to come from?
How about shattered trust in the Govt and banking system. How about the way small businesses are being crushed, not felt since the Great Depression?
There’s an awful lot of wishful thinking and optimism out there, the reality is that the BLS data understates unemployment greatly and the Banks balance sheets are still holding onto a multi trillion dollar pile of crap.
Biggest credit boom = biggest credit bust. We’ll face the biggest depression in history and maybe even worse.
Number of defaults is just the beginning of the pain… given the correlation between default rate and recoveries, high yield investors are in for the world of pain… only saving grace is the 20% yield on the bonds at the moment… the question is when the defaults will come, the later the better. more here
http://www.acredittrader.com/?p=124
you’ve got it backwards – 0% recovery is the most conservative assumption he could make. If the 53% is implied from the price of securities, a positive recovery would entail even more defaults for a given price. Think about it.
Andy,
There seems to be an internal inconsistency in the reasoning, which is probably due to the Bloomberg write-up, not the note. He is clearly using multiple methodologies, since he also talks about 40% as a floor and 50% being “not unreasonable”.
I was saying 0% is aggressive in the abstract. The implication of what he is saying, which I did not tease out, is he thinks the yield are a tad high even given that he is generally in agreement with the default rate (order of magnitude basis).