The Fed stimulus program has had a significant effect on the default cycle. The Fed’s actions have produced extraordinary liquidity in fixed income markets, helping drive default rates below 2% from a peak of 14.7% in 2009 (according to Moody’s data). This suppression of the default rate has in turn lengthened the default cycle, as all but the most distressed companies have been able to refinance maturing debt, extend maturities, reduce interest costs and improve borrowing terms.
The taper should not materially affect most corporate borrowers’ credit profiles in the near term. We expect interest rates (and therefore borrowing costs) to rise. But since rates have been very low for some time, we view this rise as just a return to a more normal rate environment. Also, higher rates will presumably be accompanied by broader economic expansion, which is positive for credit quality insomuch that increases in revenue and cash flow tend to improve corporate financial flexibility.
Default rates are unlikely to spike in the near term despite higher interest rates. We don’t expect rising rates to be a catalyst for significantly higher defaults over at least the next 18 months, provided the pace of the transition is reasonably measured and there are no major macroeconomic shocks.
Although it may seem counterintuitive, statistical studies show that default rates tend to rise when short-term rates are falling in response to a contracting or very low-growth environment (e.g., when the annual gross domestic product (GDP) growth is less than 1.5% versus a norm of about 3%). Defaults generally occur clustered together during periods of economic weakness or market crisis, and usually among the most leveraged companies. Notably, almost all companies that default have high-yield ratings, meaning they are below investment grade. It is rare for companies categorized as investment grade to default, as they tend to have healthy financial flexibility.
Marginal borrowers are more at risk from higher rates. For marginal (or most-at-risk) borrowers, a moderate increase in borrowing costs could result in failure to service or refinance debt commitments over time, increasing the likelihood of default.
Most high-yield borrowers, however, have had ample opportunity over the past several years to boost liquidity and refinance near-term maturities. And few high-yield companies now appear on the cusp of default. Refinancing in a period of higher interest rates, such as the one we are anticipating, could create more distressed companies —though probably not for a couple of years.
Credit quality among U.S. companies has a negative bias, but is still in decent shape overall. After the financial crisis, many corporations went into repair mode. They reduced capital expenditures and shareholder returns, and cut back significantly on mergers and acquisitions. This resulted in several years of very strong liquidity and low leverage, factors positive for credit quality.
However, the Fed’s low interest rate policies encouraged companies to increase debt to take advantage of low borrowing costs. Starting in 2012, leverage once again began to increase, a trend we think is likely to continue. That said, other indications of credit quality remain quite healthy: Maturities have been extended, revenue growth appears solid and margins remain relatively strong, as do cash flow and liquidity.
The trend toward increased leverage is laying the groundwork for the next default cycle. As the economy improves, management teams are likely to continue to increase their use of leverage to fund returns to shareholders and accelerate the pace of mergers and acquisitions. The trend toward increased leverage is laying the groundwork for the next default cycle as the more indebted companies become, the less flexibility they have to navigate industry or macroeconomic challenges.
However, it usually takes at least several years of credit quality deterioration before a company defaults, assuming that no near-term significant macroeconomic weakness accelerates the decline. It is important to note that default can also arise from competitive pressure, problems with a supplier, fraud or structural shifts in an industry, among other catalysts.
Defaults are unlikely to accelerate in the near term. This will largely depend on the timing and depth of economic growth and the extent to which companies leverage their balance sheets this year and next. Given that credit quality is still in decent shape, and that many more vulnerable companies have already refinanced and extended their maturities, we do not see a fundamental reason for default rates to accelerate meaningfully in 2014.