The Credit Market: When Will the Music Stop?

Credit spreads will widen and defaults will increase, say some portfolio managers. But pinpointing the 'when' is almost impossible.
Vincent RyanOctober 26, 2017
The Credit Market: When Will the Music Stop?

It would certainly help chief financial officers to know, generally, when credit spreads are going to widen again.

After all, about $595 billion of U.S. non-financial corporate bonds will mature through 2018, says the Institute of International Finance.

Over the past year, credit portfolio managers at major global banks have been pretty skeptical about credit spreads and corporate defaults. Simply put, they have expected spreads to widen and defaults to increase.

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As any bond market observer knows, however, that hasn’t been the case.

While the yield on the 10-year U.S. Treasury has crept upward since early September, to 2.45%, corporate bond spreads, if they’re moving at all, are tightening. Indeed, just on Tuesday the average investment-grade bond spread hit a post-financial crisis low, dipping down to 100 basis points over Treasuries (based on Bank of America Merrill Lynch data).

In another interesting data point, the five-year spread of an index for credit default swaps linked to investment-grade bonds was at 53, a narrow spread that indicates low demand for owning protection against a bond’s nonpayment.

About 31% of credit managers forecast a widening of North American investment-grade spreads in the next three months, according to a survey by the International Association of Credit Portfolio Managers (IACPM). About 55% project spreads will remain about the same. With regard to defaults, about 53% think the default rate will rise in the next 12 months and 36% think it will be unchanged.

“In the United States, we’re living in a period of easy credit and zero defaults,” commented Som-lok Leung, executive director of the IACPM. “At some point, that has to change, with higher interest rates and rising defaults.”

Credit moves in cycles, of course, and part of that is “just the time delay between when people make decisions concerning credit and the results of their decisions coming to fruition,” Leung said.

During times of easy credit, people and organizations use credit capacity to make investments. “Some of those investments pan out, some of them don’t, and when they don’t things default,” said Leung.

At this point, though, there are very few signs that the worm is about to turn. Bond investors continue to absorb almost every corporate issue offered to them.

But CFOs shouldn’t get complacent. BlackRock recently downgraded its view of U.S. corporate credit from “overweight” to “neutral,” citing concerns that tight spreads leave little margin of safety for investors.

In addition, total global debt is reaching very high levels. By the middle of 2017, it was up more than $7.5 trillion (3.5%) over the second quarter of 2016, according to the IIF. (The nonfinancial corporate sector added $2.6 trillion in that time period.)

Moreover, the percentage of “stressed” firms that cannot cover interest expenses has reached some 15% to 25% of corporate assets in Brazil, India, Turkey and China.

In its Global Financial Stability Report in early October, the International Monetary Fund warned of the dangers of “an ongoing buildup of debt and an extended rise in the price of risky assets.” It proposes that debt levels could “breach critical limits” by 2020.

Is that the “when” to mark on the calendar? We don’t know. That, more than anything, is what finance chiefs need to keep in mind.