Default rate is the lowest in 10 years, but the only way is up

Moody’s monthly default report shows that the global speculative grade default rate fell to the lowest level since April 1997. March’s figure was 1.41%, down from 1.58% in February, which means that just 1.41% of all high yield issuers defaulted in the 12 months to the end of March. These incredibly low default statistics have been made possible by a combination of strong corporate earnings and relatively cheap available finance, which have also helped equity markets to rally (the Dow Jones broke through 13,000 for the first time on Tuesday).

However Moody’s predict that the global speculative default rate will rise fairly steadily from current levels up to 3.5% by March 2008. To be fair, their model’s credibility has fallen a little recently (it has been predicting a rise in defaults for about a year, while defaults have in fact fallen), but there is growing evidence elsewhere that spreads could widen soon, and a sharp correction is possible.

A fascinating note from Tim Bond, a very influential global strategist at Barclays Capital, paints precisely this picture. He argues that US companies are spending much more on buying back equity than on capital expenditure relative to in previous cycles (in Q4, US non-financials bought back the equivalent of 6% of total market capitalisation – by far the largest corporate buying spree on record). This expenditure is being financed by heavy issuance in the bond markets as companies take advantage of historically low yields and record tight spreads to raise finance cheaply, behaviour which has historically resulted in companies’ balance sheets being leveraged up and higher defaults. Companies are purchasing equities with borrowed money, and this cannot enhance earnings growth in the long run – while it can boost a company’s earnings growth in the short term, it does nothing for productivity.

Perhaps the scariest chart in Tim Bond’s note for investors heavily exposed to high yield is one that plots the global speculative grade default rate against the corporate sector’s borrowing (in relation to profits). There is a very strong relationship between the two variables – when corporate borrowing increases, the default rate follows suit about 18 months later. Corporate borrowing has shot up over the past 12 months, and this suggests that the default rate will rise sharply anytime from this summer onwards.

Higher defaults means wider spreads, and we retain a cautious positioned with regards to credit rating throughout the bond fund range at M&G.


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