The credit cycle has turned, and fundamental risks are material, that’s according to Morgan Stanley’s July 1 report on the credit sector.

Back in October 2015, Morgan Stanley published a detailed research report on the state of the US credit market and credit cycle. At the time the bank came to the conclusion that credit risks were increasing, and investors should take a cautious view of the high-yield sector and wider financial markets in general.

HY credit quality has never been worse

Ten months on and according to Morgan Stanley’s research, conditions in the US credit markets have only deteriorated. The high-yield bond default rate has increased to 6.61% on par with the level two years before defaults peaked in the 2001 credit cycle. This level is also on par with the level one year before defaults topped out in the 1991 and 2009 credit bubbles. The peak high-yield default rates in these last three credit cycles were between 11% and 16%, as shown in the chart below.

Morgan Stanley: Credit risks are rising
Morgan Stanley: Credit risks are rising

Still, it’s fair to say that things are different this time around defaults in the 2008/2009 credit cycle were kept under control with the Federal Reserve’s aggressive monetary policy response. As a result, in terms of cumulative defaults, the 2008 cycle was less severe than the 1989 and 1999 corrections. The highest five-year cumulative default rate in each of these periods was 23%, 31%, and 29% respectively.

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Morgan Stanley: Credit risks are rising

This time around the Fed does not have the same tools to address slowing growth available to it, having used up almost all of its policy ammunition in subsequent rounds of QE. Nonetheless, yields around the world remained depressed on global growth concerns and loose monetary policy initiatives from other central banks around the world. The European Central Bank’s corporate bond purchasing program has depressed yields on not only European corporate bonds but also high-yield US bonds as investors are forced to look overseas for yield.

It could be argued that these easy money policies are now having a detrimental effect on the credit markets. Granted, at first glance, credit quality may look to have improved as CCC issuance has dropped all the way to 3.5% of total high-yield supply, but leverage remains elevated across the board. For example, at the 2007 credit market peak, the average leveraged ratio of high-yield issuers was 3.6, compared to 4.5 today. Investment-grade gross leverage was 1.8 times in 2007 compared to 2.3 times today.

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However, as Morgan Stanley goes on to report other leveraged metrics aren’t so concerning. LBO transaction volumes were only $186 billion at the top of this cycle, compared to $434 billion in 2007, consumer credit growth peaked at 4.3% in this bull market compared to 16.9% in the last. M&A/LBO issuance peaked at 55% of total high-yield/loan supply in this cycle, compared to 74% in 2008. C&I loan growth peaked at 15.2% (currently 9.2%), compared to 18.3% in early 2008 and 16.1% in late 1998. And LTM high-yield/loan new issuance accounted for 40.3% of the outstanding high-yield/loan market this time (currently 16.6), compared to 52.4% in 2007.

Put simply, there are signs that the credit cycle is turning although the data isn’t as supportive as it has been in the past. Morgan Stanley isn’t buying the optimistic argument:

“We do not think these ‘lower cycle risk’ data points mean default potential is not material – just that the problems are always different each time around, and the signals can change from one cycle to the next. This time, the US consumer and the financial system are in much better shape, but in our view, the non-financial corporate universe is not.” – Morgan Stanley on the turning credit cycle.