Source: JP Morgan.
Note: High-yield bonds represented by the JP Morgan High Yield Index.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.
Recession Unlikely
In addition to evidence that credit is readily available, signs of a U.S. recession that typically align with the end of a credit cycle are difficult to find. As economist Rudi Dornbusch once said, “No postwar recovery has died…of old age—the Federal Reserve has murdered every one of them.” The glacial pace of current Fed policy, however, can hardly be characterized as “murderous.” In addition, the other preconditions that generally force aggressive, “murderous” tightening are not apparent. Aggressive rate hikes typically are prompted by robust economic growth (something we’re still waiting on) that leads to stepped-up borrowing for expansion in order to take advantage of the opportunities created by strong growth. If these conditions exist, they should produce the excessive inflation that aggressive Fed rate hikes are designed to correct through economic slowdown. Today’s economy fails to resemble such conditions.
If recession seems unlikely and credit is available, the increase in defaults and debt issuance still demand analysis and explanation. After several years at historically low levels, defaults on high-yield bonds increased, to 3.52%, in August 2016, above the 25-year average of 3.27%, according to JP Morgan. It is important to note that most of those defaults are related to problems in the energy sector and a few in the related area of metals/mining. In fact, excluding the energy and metals/mining sectors, the default rate was only 0.53%.
The problems in energy are driven by the large increases in oil supply—from U.S. producers as well as Saudi Arabia—that pushed prices dramatically lower. The fundamental weakness in energy seems sector-specific, not a symptom of a bigger issue that affects broad economic health. In addition, lower-priced energy does not damage the economic fortunes of most other companies; in fact, it likely represents a cost-reduction benefit. If lower-priced oil were a function of reduced demand because of reduced economic growth, non-energy companies would be in weaker positions as well, and broader default concerns would be justified; but it is supply not demand that is behind the price decline. Metals and mining are similarly affected by additional supply created in anticipation of increasing demand, largely from China.
Defaults, then, seem driven by supply issues specific to a few sectors, not the consequence of a broader economic event provoked by aggressive rate hikes and poised to undermine broad corporate health.
In terms of the level of borrowing, much of the debt increase since the 2008–09 recession may be appropriate given the historically low level of rates. Most of the increase in debt issuance has been for refinancing and not for speculative activity such as leveraged mergers and acquisitions. From 2009 through 2015, just over 58% of new high-yield issues were for refinancing, similar to almost 55% so far in 2016, according to J.P. Morgan. This compares to a little more than 36% in 2006 and 2007, prior to the recession, when borrowing for more speculative activity such as leveraged buyouts (LBOs) was more prevalent. The J.P. Morgan data show that only 20% of new-issue proceeds between 2009 through 2015 and 17.4% in 2016 (through August 31) were used for acquisitions or LBOs, compared with an average of almost 48% in both 2006 and 2007. Higher debt issuance since 2008 reflects a prudent use of historically low interest rates, not blind leverage, to increase the sector’s risk profile.
Summing Up
The availability of bank credit, and the willingness of lenders to fund lower-quality credits without prohibitively high rates, suggests that we remain in the expansionary phase of the U.S. credit cycle. The absence of preconditions typical to recession further supports the thesis that a credit downturn is not unfolding. The nature of the increase in defaults seems a rational outcome of specific conditions in the energy and metals/mining sectors. The high level of borrowing appears appropriate, given historically low rates and the level of refinancing to take advantage of an opportunity to reduce corporate borrowing costs.
Continued "lower for longer" monetary policy, combined with some fiscal stimulus in the form of infrastructure spending, could prolong the economic and credit cycles, which would keep defaults at bay and allow investors additional time to capture attractive income in a variety of bond credits.
Zane E. Brown is a partner and fixed-income strategist at Lord Abbett.