DEUTSCHE BANK: Get ready for a junk-bond default cycle to start in 2017

One of the biggest sources of anxiety among investors at the start 2016 was the high-yield bond market.

Specifically the market for high-yield (or junk) bonds issued by oil and gas companies.

As the price of oil plunged below $30 in January and February, so investors rushed to sell debt issued by companies who needed expensive oil to stay profitable.

But the ticking bomb that people were expecting to explode — a wave of defaults rivalling the sub-prime housing crisis of 2008 — hasn’t yet.

Investors are about a year early with their concerns, according to a report by analysts at Deutsche Bank, with the default cycle for junk bonds expected to peak in 2017 or 2018.

Here are US credit strategists led by Oleg Melentyev (emphasis ours):

This analysis suggests we need the combination of three conditions for us to be confident the next default cycle is around the corner. We need the accumulation of excessive debt and preferably of deteriorating quality, some kind of external shock/trigger and a sharp flattening of the yield curve.

Throughout this analysis there is no definitive smoking gun evidence that the next default cycle is round the corner but we’re building a theme that a combination of factors are pulling together to increase the risks of the cycle turning.

At the moment, about two out of three are arguably in place, with debt levels increasing and the external shock appearing in the form of low oil prices.

Here are the charts:


There’s also another handy indicator.

For the past three default cycles, including the telecoms and tech crash of 2001 and the financial crisis of 2008, bank stocks have seriously underperformed the wider market.

Here’s Deutsche Bank again:

Our US strategists have pointed out that US Financial equities have tended to underperform the S&P500 by 15-20% in the year leading up to the previous three default cycles we’ve identified.

As we stand today they are underperforming the index by around 10% since reaching their recent peak level in Aug 2015. Within Financials, US banks are underperforming SPX by 19%.


So it looks pretty bad for next year, but just how bad will it get?

Overall, Deutsche Bank sees defaults peaking at 4%, or one in 25 debt issuances, for the high-yield market, rising to 9-11% for oil and commodities companies. That’s still way lower than past default peaks at as much as 15%.

There are two wild cards at play that keep defaults low or help avoid a cycle entirely. The first is loose central bank monetary policy, which, if it continues into next year and the year after, could help companies refinance cheaply and service their debt without too many complications.

The second is in the form of government action. If governments start spending and investing, boosting growth and demand for oil and commodities, then profits at those companies would also start to increase, reducing the likelihood of a wave of defaults and toxic debt.

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