Worldwide corporate defaults are on the rise. The number of defaults has reached its highest level since 2009’s crisis period, with well over 40 defaults including the failure to service over $50 billion in debt so far this year. This is largely attributed to the energy and mining sectors which have been debilitated by persistently low oil prices, as well as the softening of global demand for commodities. Some warning signs came in March with Standard &Poor’s (S&P) tagging 242 companies as “weakest links” (that is with high chances of downgrades), up from 235 in February.
Corporate America Stressed?
Corporate America accounted for ~80% of the delinquencies this year. What’s more, this April, U.S. High-Yield (HY) bonds registered their largest monthly defaults in two years at $14 billion, according to a Fitch Ratings report. The same report estimates the speculative-grade default rate to come in at 3.9% for the 12 months ending April, higher than the 2.1% rate as compared to the same period the previous year. Also, a March 2016 report from S&P mentions that the 2015 average credit rating of non-financial U.S. corporate borrowers plunged to 15-year lows, which could be a sign of further stress in coming months, particularly for low quality debtors.
Until the Fed’s recent policy rate hike, the 2008 post-financial crisis years were supported by monetary easing—facilitating easy borrowing conditions for companies. During the same period, investors’ growing risk appetite influenced them to buy speculative-grade debt in exchange for higher yields. But, these risky bets seem to be unraveling at present, especially for U.S. energy exploration and mining companies that are failing to meet obligations under a crushing commodity rout.
Furthermore, Fed-induced interest rate hikes (which are generally an indication of the maturing of a credit cycle) could make refinancing harder for sub-investment grade borrowers. As the cycle wears on, they may also be facing a waning appetite for riskier debt from investors.
Do Defaults Spell U.S. Recession?
So, does the recent surge in corporate defaults point to the next U.S. recession? It’s too early to say, we believe. First, the defaults are mostly from the mining sector—an industry that contributes less than 2% of the U.S. value added as of Q3 2015. On the other hand, sectors occupying a larger slice of the economy, such as real estate, are experiencing gradual but steady recovery, largely due to firming domestic fundamentals. What should also be comforting is that excluding metals and energy, the U.S. High Yield default rate by the end of 2016 is expected to be in the 1.5%-2% band, which is lower than the non-recessionary average of 2.2%, as suggested by a March report from Fitch.
Also, more stringent lending conditions, adopted by banks of late, should help stem delinquency rates going forward. As it is, most major banks’ loan portfolios do not have more than 3% exposure to the energy sector.
Bottom Line for Investors
Although it wouldn’t be too surprising if the recent surge in corporate default rates heightens concerns among equity holders, it should importantly be noted that the delinquencies are largely concentrated in energy/mining companies, with many of them already bearing “junk” status. Investors looking for investment grade corporate bonds will have plenty of other places to look, namely in the 8 sectors of the U.S. economy not called “Energy” or “Materials.”
Disclosure