Beneath the Aggregates: Growing List of “Idiosyncratic” Collapses

Viewpoint

June 14, 2019

  • Backward looking indicators of credit market stress, such as trailing default rates, are anchored at cyclical lows, though these, by definition, embed little information about prospective conditions and activity.
  • Still, concurrent and leading indicators, such as credit spreads and distress ratios, while elevated relative to this time last year, aren’t yet flashing red in the aggregates.
  • Beneath the surface, however, an appreciable number of (seemingly) disjointed sectors and capital structures have begun to break … and the list continues to grow.
   

Important inflections in the credit cycle are rarely observed initially in the aggregates, but rather are found in the idiosyncrasies underpinning the market. Our bottom-up investment process extends beyond our fundamental credit analysis to an appreciation for trends emerging beneath the surface. One such observation has been the complete collapse of a growing number of high yield capital structures. Though not yet apparent in the aggregates, these occurrences may prove prescient regarding prospective market conditions.

Default rate near cyclical lows, but what does this tell us?

Few high yield issuers defaulted over the trailing 12 months. Indeed, just 22 borrowers in the context of a marketplace of near 2,000 credits. In terms of the quantum of debt, the last 12-month default rate, as of the end of May, stood at 2.3%. But what insight does this data embed? Information about the past no doubt. Capital was available for a broad universe of leveraged borrowers, allowing even marginal credits to “kick the can down the road” and remain current on their debts. But what does that tell us about prospective risk tolerance and capital market conditions? Well, empirically very little. Looking at the last two significant default cycles – one broad-based during the financial crisis and the other more acute to the Energy sector in late- 2015/early-2016 – trailing default rates hit local lows before exponentially increasing over the subsequent months:

LTM HY Default Rate (1995-2019)

Source: Bloomberg / Barclays US HY Index

LTM HY Energy Default Rate (2006-2019)

Source: ICE BofAML US HY Energy Index

Credit Spreads and the Distress Ratio

Prevailing credit spreads for high yield bonds (i.e. the premium over the risk-free rate demanded by lenders to compensate for credit risk), in addition to the percent of bonds trading with a spread greater than 1,000 basis points (bps) (defined here as the distress ratio), are far more informative of the path forward, particularly the latter. This intuitively makes sense, as growing risk aversion inflates credit spreads and tightens lending conditions. This, in turn, restricts capital to only the most creditworthy borrowers, shuts out marginal credits and forces restructurings. Empirical correlations are evident as well:

HY Distress Ratio vs. LTM HY Default Rate

Source: Bloomberg / Barclays US HY Index

HY Energy Distress vs. LTM HY Energy Default Rate

Source: ICE BofAML US HY Energy Index

As is evident above, building credit stress (distress ratio) foreshadows defaults, whereas trailing default rates are just that, “trailing,” and therefore lack predictive power. On average, high yield credit spreads currently sit around +400bps, and the market distress ratio is ~6%. Both are higher than a year ago (credit spreads were inside of +350bps in June 2018 while the distress ratio was ~4%), but taken in the context of a full-cycle continuum, still remain near the lows:

 HY OAS (2017-2019)

 HY OAS (1986-2019)

Source: Bloomberg / Barclays US HY Index

Beneath the surface, however, appreciable stress is building

While the aggregates appear to register relative stability and muted systemic credit stress, we have observed a number of capital structures this year that have begun to topple (and with increasing regularity). Year to date, a total of 21 high yield issuers have seen the price of their debt drop by 10 points or more. This is significant considering where risk asset prices stood at the start of the year following the December sell-off. Since the cyclical tights in spreads on October 3, 2018, there have been 86 issuers that have fallen by 10 points or more in price, with several experiencing drawdowns between 40-50 points! Though more interesting than the number of incidences, is its composition and evolution. What appeared initially isolated to the Energy sector, specifically Independent Exploration & Production and Services companies, has broadened to Retail, Autos, Pharmaceuticals and Metals & Mining. Moreover, the size of capital structure has begun to grow, with early stress confined to smaller credits such as Jones Energy (JONE), Alta Mesa (ALTMES), Bristow (BRS) and Sanchez Energy (SNEC), whereas recently, larger, more widely syndicated bonds have collapsed (including, Weatherford (WFT), EP Energy (EPENEG), Mallinckrodt (MNK), US Steel (X) and JC Penney (JCP)):

Number of Issuers with > -10pt Drawdown in Price Since October 3, 2018

Source: Bloomberg / Barclays U.S. HY Index

But are these sell-offs unrelated/purely idiosyncratic, or indicative of a systemic trend? On the surface, the various drivers appear rather disjointed – lower oil prices, underwhelming well results and service price deflation (Energy) versus opioid litigation and Medicaid reimbursement pressures (Mallinckrodt) versus trade-related commodity price volatility (U.S. Steel). However, evident across each case is a swift and significant withdrawal of investor sponsorship. This lack of willingness to extend credit has a powerful ability to compound. When companies lose incremental access to the capital markets, investors rush to sell before the next domino falls (as loss aversion fuels risk aversion). Capital therefore becomes less readily available, resulting in distress, defaults and principal loss. Said another way, the capital market itself has the ability to transmit seemingly isolated incidences of credit stress systemically. As such, elevated levels of distress, observable in select sectors/capital structures, has the potential to permeate more broadly:

Distress Ratio by Sector (May 31, 2019)

Source: Bloomberg / Barclays U.S. HY Index

Conclusion

To end with an analogy:
Picture driving along a multilane highway. You observe an accident just ahead, so you change lanes. You are driving more cautiously now but remain on the highway. You then observe another accident, so you change lanes again. How many more iterations before you just get off the highway?

Credit-specific collapses are becoming more frequent (and greater in scale and sector reach). While idiosyncratic in their drivers, disjointed they are not. Each credit event compounds a growing risk aversion which has the potential to transmit broadly. 

 

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