The markets don’t seem to care that corporate defaults — US companies failing to pay their debts — are heading back up to territory last seen in 2009, when the financial crisis hit bottom. Everyone feels reassured that while the default rate is getting worse, it’s not as bad as it could be, and that therefore means it’s relatively good.
Let’s hope the optimists are right. Because this time around we’ve got defaults ticking up in the US and China at the same time — and that’s scary if you’re a pessimist.
Deutsche Bank analyst Jim Reid produced this chart of non-financial debt (ie companies) and defaults by companies rated Single-B. We have annotated it in red with the rough dates of recent major recessions:
We’re currently at the bit marked with a “?” Defaults are ticking up, but they’re not too bad, right at the same time that debt to GDP is on the rise. The cycles match, broadly.
OK, so where we are at now is not as bad as it was in ’91, ’99 or ’09. While debt levels are high, they’re not excessive yet and underwriting standards haven’t slipped as far as in previous cycles.
Here’s Reid (emphasis ours):
The buildup of excess is often a pre-requisite for bubbles to burst or for economic cycles to be vulnerable to shocks. One argument for why this US economic cycle might still be able to run for a few years is that many economists feel that excess hasn’t been as prevalent as in prior cycles.
However one can argue there has been a sizeable increase in US corporate debt since the GFC comparable to increases prior to previous default cycles.
But look what’s happening over in China: There has been a little-noticed wave of defaults by Chinese companies, hitting a record at the end of last year in terms of total renminbi owed, according to Bank of America Merrill Lynch:
Chinese companies have doubled their debt load since 2010. Clearly, some of them aren’t capable of carrying it.
Now add into the mix China’s state-owned enterprises (SOEs). The Chinese government has massively ramped up the amount of credit it has extended to its various government-controlled businesses, partly to keep SOEs liquid and partly to prevent them collapsing. Currently, the consensus belief is that China will somehow muddle through, and these debts will either be repaid in the long-term or abandoned without collapsing the Chinese economy.
Chinese companies just found a new way to take on debt, too: By borrowing it from the US in the form of issuing riskier “high-yield” bonds in US dollars. Deutsche Bank analyst Vikash Agarwalla wrote in a note to investors recently:
This space has grown from being non-existent to close to about 20% of HY China Industrial outstanding notional. To put things into perspective, out of the total supply of about USD3.6 billion in China HY Industrial space in 2015, USD2.2 billion came from this sector.
It’s not easy to figure out the quality of these Chinese HY USD bonds, Agarwalla says, because “it is difficult to actively track these names given limited or no public information.” (That sentence on its own is scary — it is not often you see an analyst admit he has no information on a market he’s trying to track.)
So, to recap, US companies are increasingly defaulting on their debt, Chinese defaults are rising too, and yet both Chinese and American enterprises are still taking on more debt.
What could possibly go wrong?
If you’re a pessimist, the scenario of the two largest economies on the planet both owing money they cannot pay is a genuine threat to the financial system.
Of course there is the optimistic version, too. As long as both China and the US can grow their economies faster than their debts, then the defaults remain benign, not contagious.