Deutsche Bank Says World "Past The Point Of No Return" In The Default Cycle

Over the past year, the credit cycle finally turned, and has unleashed the latest default cycle. In fact, as BofA's Michael Contopoulos warned last week, it may be the worst default cycle in history with "cumulative losses over the length of the entire cycle could be worse than we’ve ever seen before."

Over the weekend, the FT got the memo with a report that "global company bond defaults at highest level since 2009" in which it said that "the global bond default rate by companies is running at its highest since 2009 with the US accounting for the vast majority, according to rating agency Standard & Poor’s. A further four defaults this week, with three coming from the troubled oil and gas sector, pushed the overall tally to 40 with a little over a quarter of 2016 done."

To be sure, the US default cycle is bad and getting worse. But how much worse?

The latest to attempt that answer is DB's Jim Reid who in his just released 18th annual default study explains why his "late cycle fears continue to build." These are some of the highlights:

There are clear signs the cycle is turning, especially in the US. Our US strategists have previously suggested that we need the combination of three conditions for us to be confident the next default cycle is imminent. We need the accumulation of excessive debt and preferably of deteriorating quality, some kind of external shock/trigger and tighter monetary policy/a flattening of the yield curve. The pieces of the jigsaw are building. US corporate debt accumulation now compares with that seen prior to previous default cycles. Equity volatility has seen two spikes in the last 12 months (August and early 2016), bank equity is falling (a lead indicator of lending?) and global yield curves continue to flatten.

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From the conclusion:

The artificial ingredients keeping defaults below their 1983-2003 levels are still broadly in place so although we expect the next default cycle to be round the corner it could still be mild relative to the early 90s and early 00s cycle and even the already subdued 2009 cycle which was very short, especially given the economic wreckage seen.

As we’ve suggested in previous editions of this report, this is likely due to the increasing artificial demand for fixed income seen over the last 15-20 years which effectively allows more financing opportunities for levered companies at lower yields than they might be asked to pay if global fixed income markets were a perfectly free market where the only consideration was relative value. Over the last two decades, SWFs, pension funds, insurance companies, banks and more recently central banks in great size have distorted the demand for and yield of global fixed income. This is unlikely to change and although the Oil and Gas sector demonstrates that bad fundamentals can still win out, for more marginal companies, the artificial conditions in fixed income could still help prevent a more savage cycle.

Obviously the Oil and Gas sector will play a big part in determining the overall level of defaults and in a separate section our US strategists detail their expectations for defaults in this sector and how that will filter through into the wider US HY market.

It’s also true that credit spreads are relatively elevated and price in a default rate markedly higher than current levels. Indeed as we’ll see throughout the body of this report, at an aggregate level a buy-and-hold investor would need to see defaults worse than virtually all observed periods through history for them not to get a positive excess return relative to Government bonds from this starting point. However if we do see a recession even if defaults are relatively subdued the illiquidity of financial markets could easily see big mark-to- market losses. Recession tend to bring big overshoots in credit spreads relative to default risk anyway. So lower structural defaults may not provide comfort in the heat of the next recession but current spreads should give longer-term investors some comfort across the vast majority of sectors.

All of which perhaps explains why the ECB is well on its path to monetizing junk bonds once it is done with investment grade corporates.