- $5.4 trillion in risky corporate debt is vulnerable to default and credit downgrades as the coronavirus crisis deepens, UBS strategists estimate.
- Investors leaned into this corner of the market during the economic expansion for income they could not earn in the safety of Treasuries.
- In its current form, the Fed's huge stimulus plan is not enough to stave off defaults, according to UBS.
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One of the questions UBS strategists say they are fielding a lot these days concerns companies that may default on their debt obligations.
In response, the experts attempted to quantify the damage that this crisis will do to the $8 trillion corporate-debt market. Their clients' fears are understandable, considering that the economic standstill necessitated by the coronavirus pandemic is rapidly shrinking corporate earnings.
Investor sentiment was different just a few months ago when the economic expansion was still in full swing. Even riskier parts of the debt market provided a win-win scenario to companies and investors: borrowing costs were historically low for firms that needed to tap credit, and investors could earn higher yields than those offered by Treasuries.
The tide has changed very quickly, however, with ratings agencies now swinging into action to downgrade companies once thought to be sufficiently solvent. Fitch Ratings, one of the big-three agencies, now has a "deep global recession" as its base case for 2020.
Within the context of a downturn, UBS analysts are primarily concerned about companies that lack investment-grade ratings, meaning those that have higher default risk.
"The key area of vulnerability is the $5.4tn in non-investment grade debt, including global leveraged loans ($3.2tn), middle market loans ($1tn) and US high yield ($1.2tn)," said Matthew Mish, the head of credit strategy, in a recent note.
He added, "Cumulative defaults could approach $0.5- 0.75tn."
The chart below illustrates the growth trajectory of these markets during the expansion - and what is at stake now that companies are facing solvency challenges.
UBS
Mish concluded that high yield and leveraged-loan spreads are implying a default rate of 9-11%. For context, the peaks during the last two recessions were 10% and 12% - so such an outcome would not be in line with history.
The oil-price war between Saudi Arabia and Russia is stressing the energy sector and worsening the default outlook for high yield, Mish noted. But more broadly, his dire forecast can be explained by the debt binge many experts have been flagging as a risk.
"Our prior work shows quality of issuance better explains cumulative default trends since 1930," Mish said. "And this cycle has seen a record share of speculative grade issuance (62% of the non-financial corporate supply), led by loans. In the global pandemic scenario we estimate peak defaults of 10%, 14% and 18% for US high yield, leveraged loans and money market debt."
One way to limit defaults in these markets is direct intervention by the Federal Reserve.
But so far, the Fed has excluded these risky markets from its colossal stimulus plan that will provide up to $300 billion of new financing.
"The program is concentrated on short-dated (1-5yr) investment, not speculative grade debt," Mish said. "We think the Fed would need to expand their program out the IG credit curve and to noninvestment grade debt."
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