Default Rates Continue to Trend Down
27 September 2017 by Felipe Villarroel
Yesterday Fitch Ratings published an update on default rates for the first half of the year. Numbers were very low once again, which continues to support one of the pillars of our positive view on credit vs rates products. There were no defaults in IG rated credits and non-IG defaults were lower than in the first half of 2016. The number of corporate issuers that defaulted in the first half of the year totalled six, all of which had a High Yield rating at the time of default. This resulted in a HY default rate of 0.64%, down from 1.9% for the same period in 2016. Looking at the distribution per rating bucket we note that, as one would expect, CCC default rates were the highest at 5.7% while single Bs and BBs came in at 0.57% and 0.19%. All three of them were lower than H1 2016 with CCC defaults at 17.91% in that period, so quite a move. Per geography trends are not different. In North America, EMEA and Latam, corporate default rates were lower in H1 2017 compared to H1 2016. Latam in particular was the only region with no defaults at all after showing the highest default rate in H1 2016. Asia Pacific figures were virtually the same as in H1 2016.
These are very positive figures for credit investors and show that the strength of a coordinated global economic recovery shouldn’t be underestimated. Although spreads look fairly expensive compared to history, we have a combination of factors, including very low default rates, that support these valuations. We would rationalise therefore that given this backdrop, spreads should be expensive and remain expensive until a negative shock changes the environment for the worse.
We would note however that it is unlikely that next year we will see default rates going much lower. The cycle is now older and this year we have seen a more “normal” recovery. Consequently, the Fed will continue hiking rates, the ECB will most likely carry on with their gradual exit strategy of the QE programme and the Bank of England will likely hike rates at least once in the not-so-distant future. As long as they are combined with a continuation of the positive macro trends, these very gradual changes in monetary policy shouldn’t result in a more bearish environment for credit.
So how do we trade this trend? As the cycle progresses, credit quality in portfolios should gradually increase. We would stress the word gradually as this cycle has the potential to age very slowly indeed. However selective action should still be taken. CCC rated bonds hardly compensate investors for the default risk that they bring and we would question holding anything but highly selective exposure at these yield levels. The gap in the default rate to Single B is always big, but currently the spread is not.
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