Inflection point reached in credit cycle
The credit cycle has reached an inflection point that could mean much tougher times ahead by 2024 and 2025. This is according to Ed Altman, Max L Heine Professor of Finance, Stern School of Business, New York University.
The benign part of the cycle, enjoyed by US markets and borrowers since 2010 looks like it might be over, Altman told RiskMinds International in Barcelona.
The credit market has already transitioned to average credit conditions, with several indicators showing a distressed cycle, according to Altman, who is also Professor Emeritus at NYU Stern and Co-Founder of Wiserfunding.
Altman primarily uses five credit cycle indicators:
- default rates – current and forecasted;
- recovery rates – weighted average price at default;
- investor required rates of return;
- high yield bond distress ratio;
- and liquidity, using several indicators, including “CCC” rated issuance.
“We have reached the inflexion point from a benign to an average point in the credit cycle,” said Altman. “It’s distressed but I’m not forecasting crisis in 2023. It’s 2024 and 2025 that I’m concerned about, if inflation continues to be at high levels and this recession is still with us.”
The coronavirus pandemic has already transformed levels of debt in the financial system, he warned. Financial sector debt has not grown due to regulatory constraints, but government debt globally is already at 100% of GDP on average. Household debt has also grown, albeit more modestly, Altman noted.
“That wasn’t relevant last year because interest rates were so low, but now, it’s incredibly relevant,” he said.
Governments find themselves in a difficult position now interest rates have risen to combat inflation, he suggested, with more money spent on interest and less available for fiscal or infrastructure growth, or to support either the private sector or struggling households with subsidies during an energy crisis.
“It’s going to put tremendous pressure on financial markets going forward. We’re going to see some governments struggling with that burden, so I think the sovereign risk model needs to be resurrected,” Altman said.
Altman emphasised high yield debt – i.e. junk bonds – as the first area he looks at to understand the credit cycle. He noted that in high yield bond issuance was at its highest in 2020-2021, snapped up by the market in an anaemic interest rate era.
“We put a tremendous amount of risk into the system. For every dollar of bank debt there was more than two dollars of non-bank debt issued,” said Altman.
Defaults and bankruptcies remain extremely low, he noted, but this will change, he emphasised.
“That is a mirage of what is going to happen in 2023,” he said. “As we get more stress in the system, default rates will rise.”
Where there are defaults, a more benign cycle tends towards a higher recovery rate, Altman noted. In 2022, for example, corporate bonds have enjoyed an above-average 60% recovery rate, with that figure rising to 70-80% for corporate loans.
However, rates of return required for high yield bonds have moved from 3% to 5.5%, which Altman characterised as moving from a benign to an average situation – again painting a picture of a market current in balance, but trending towards more stress ahead.
He noted that with US 10-year Treasury bonds are at a 4% interest rate, while high yield bonds are issued at 9-9.5% rates in some cases, while distressed debt is at 14%.
“Historically about 8-10% of high yield is at a distressed level, it was 2% at start of year, and today it’s over 10%,” Altman warned.
Liquidity has already decreased and continues to tighten, he suggested.
“If you look at high yield market, liquidity has dried up almost completely. I don’t see that changing in the near future,” he said.
Measuring liquidity can focus on volatility or other measures, but he said he prefers a simpler litmus test for liquidity: the amount of new issuance taking place in the lowest grades of the debt market: “CCC” rated issuance.
“In 2022 there was only one issue of “CCC” debt in the US and it was at a hugely high interest rate. Every other issuer did not come to market, and in my opinion, there is no liquidity any more in the corporate debt market at high risk levels,” Altman said.
The Altman Z Score has already started to move for high yield debt. Next year he forecasts what would be the historical average: a default rate of 3.3% for high yield bonds, but with significantly more stress to follow in the two following years.
“In 2024 and 2025 that I expect there will be an explosion of defaults in the bigger company high yield bond markets, and I’m really concerned about small to medium sized enterprise (SME) market,” Altman said.
“Someone once said, never forecast; but if you do, never put it in writing; but if you do, do it frequently,” Altman added.
Banks in the US and Europe are already pulling back from lending to SMEs, he warned.
“SMEs are an incredibly important sector, particularly in Europe, and increasingly so in the US economy,” Altman added. “A big question is whether non-bank lending will step in?”
