Slides from the Grant’s Conference – Debt Defaults: A Growth Market by Martin Fridson, CFA – Lehmann Livian Fridson Advisors LLC

How Much Speculative Grade Debt Will Default In This Cycle?

Assumptions:

Default surge begins in 2018. (2016 reprises 1986 false start.)

Recent trend in number of issuers continues until start of default surge.

Cumulative default rate in line with normal default rate surges of past.

Private debt default numbers reflect ratio of private to public speculative grade debt outstanding.

Projected Market Size

Number of issues in BofA Merrill Lynch Global High Yield Index

August 31, 2016 = 1,630
Recent growth rate (3 months) = -7 issues/month

Projected number of issues Jan 1, 2018 = 1,518

Face Amount/Issuer = $1.324 B Total Debt/Bonds Multiplier

  • Moody’s issuers/BAML Global High Yield Index issuers = 1.8X (Jan 1, 2015)
  • Altman-Kuehne 2015 face amount (Loans + Bonds)/Loans = 2.0X
  • Median = 1.9X

Projected January 1, 2018 market size = 1,518 X $1.324 B ( Issuers Face Amount) X 1.9 (Multiplier per Issuer) = $3.819T

Default Rates in Previous Default Surges

Debt Defaults

Debt Defaults

Our projection assumes a normal-length (4 to 5 years) default surge.

The projected default rate is the median of the percentages for Surges 1 and 2, or 31.2%.

Projected Default Amount in Default Surge Beginning in 2018

Debt Defaults

The large total reflects long-run growth of the speculative grade universe, rather than an expectation of exceptionally severe economic distress in this cycle.

Current Fallacies

Fallacy #1: “High yield bonds have decoupled from oil prices due to improvement in credit quality of Energy Universe”

Debt Defaults

Percentage of monthly variance in BofA Merrill Lynch US High Yield Index’s option-adjusted spread versus Treasuries explained by NYMEX 1st Crude Future, West Texas Intermediate.

Source: BofA Merrill Lynch Global Research, used with permission.

Crude oil prices historically had no impact on high yield risk premiums. When oil prices plunged in 2014, the connection became very strong.

Debt Defaults

Based on NYMEX 1st Crude Future, West Texas Intermediate and BofA Merrill Lynch US High Yield Index Sources: BofA Merrill Lynch Global Research, used with permission; Bloomberg
Debt Defaults

Based on BofA Merrill Lynch US High Yield Energy Index Source: BofA Merrill Lynch Global Research, used with permission.
It is true that downgrades from the investment grade category increased as a percentage of high yield energy issues after oil prices began their plunge.

Debt Defaults

[drizzle]Ratings distribution of issuers in BofA Merrill Lynch US High Yield Energy Index Source: BofA Merrill Lynch Global Research, used with permission. Contrary to claims of some market participants, the July decoupling of the crude price and the high yield spread cannot be explained by improvement in the quality of energy bonds.
Debt Defaults

Based on NYMEX 1st Crude Future, West Texas Intermediate and BofA Merrill Lynch US High Yield Index Sources: BofA Merrill Lynch Global Research, used with permission; Bloomberg
Fallacy #2: “The main reason that distressed debt hedge funds have underperformed the distressed index is that they avoided making one big bet on oil prices.”

Debt Defaults

Source: BofA Merrill Lynch Global Research, used with permission; Financial Times
Debt Defaults

Based on BofA Merrill Lynch US Distressed High Yield Index Source: BofA Merrill Lynch Global Research, used with permission
Debt Defaults

Based on BofA Merrill Lynch US Distressed High Yield Index Source: BofA Merrill Lynch Global Research, used with permission
See the full PDF below.

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