Long-time credit market observer, Marty Fridson, gave an interesting speech at the bi-annual Grant’s investment conference in NY. In the speech he used a few landmark historic datapoints in order to arrive at a spectacular prediction for a cataclysmic default wave. He predicted that as much as 1.6 trillion of leveraged loans and junk bonds could default from 2016 to 2020!
Here is the link to the presentation
Fridson pointed out that junk bond issuance has been growing by 12 percent p.a., at the same time that nominal GDP has been rising by a mere 4 percent annually. The loose monetary policies of the past decades have produced ever rising levels of debt, coinciding with a fall in average quality: whereas in 1999 merely 13 percent of borrowers in the Moody’s universe were rated Caa to -C , the current figure is closer to 22,2 percent! In line with steady rising debt levels, default peaks have increased every cycle: the default rate in 2009 set a record 13.3 percent, up from 10.8 in 2001, again up from the 10.8 percent reached in 1990 during the height of the savings and loan crisis. Makes sense! What was unusual in the last cycle however was its brevity, as can be seen in the chart below.
The last downturn was highly unusual: Although the default rate hit a record 13.3 percent in 2009 the default rate dropped below its long term average (4.6%) already the next year (2010: 2.4%), whereas historically the default rates hovered above the long term average for 4-5 years after the peak. It is not difficult to guess the main culprit: the Fed, through low interest rate policy, saved a lot of overlevered issuers. Fridman also noted that historically default waves occurred every 4-7 years, which is why he expects the next one to start in 2016 the latest. As you might have guessed: the market doesn’t seem to care, the average junk spread trading more than 200 basis points below its long term average.
In my view Fridman’s speech is a bottom-up testimony to the validity of Austrian Business Cycle Theory. Low interest rates not only lead to malinvestment, as evidenced by the three times faster increase in debt compared to GDP and the deteriorating average credit quality, but also hamper the recovery by suspending the forces of creative destruction and keeping Zombie companies alive. This figure sums it up neatly: cumulative defaults between 1989-92 amounted to 31%, between 1999-2003 they raised to 37%, whereas a paltry 17% defaulted cumulatively during the Great Recession. With that much unfinished business, the slow recovery should come as no surprise to anyone.