Mike Dolan

LONDON (Reuters – Someone needs to shake the junk bonds market if there’s an economic disaster.

Jamie Dimon (NYSE: JPMorgan) was publicly worried last week by JPMorgan boss that even though the sun is still shining in financial markets, a “hurricane” would soon be our way.

A economic hurricane could be defined as rising inflation, higher borrowing rates and increased unemployment. Surging defaults and bankruptcies are the most significant indicators of an economic superstorm for bond investors as well as businesses.

Like ailing stock market, U.S. corporate bonds are already experiencing a troubled start to 2012. Investment indexes and exchange traded funds dropped between 10-15% and borrowing rates rose after two consecutive years of record-lows.

Yet the yield premium for ‘junk bond’, the more risky sub-investment-grade corporate bonds over U.S. Treasuries, remains lower than average spreads in the last twenty years. They are where they were during much of the previous decade, even if there has been a three-month pandemic. U.S. junk would have earned an average return of 5.5% annually over the past ten years.

Investors should be concerned if the climate is one of low inflation, low interest rates and slow growth with no recession.

His JPMorgan economists don’t expect the U.S. to enter recession next year, despite Dimon’s warning. Those who are able to do so will remain in a minority even though David Waldron (NYSE:), chief operating officer of Goldman Sachs, spoke last week about the difficulties posed by an unusual confluence.

However Deutsche Bank ETR: is one of few forecasters that can formally predict two quarters of U.S. economy contraction in the second-half of 2023. Its view on the effect on corporate defaults suggests that there may be gale force winds.

An annual assessment of corporate credit outlook was called “The end to the ultra-low default environment?”According to strategists Jim Reid, Karthik Nagalingam and Karthik Nagalingam, the U.S. default rate will rise from its historic lows of 1% to 5% next year and then double to 10.3% by 2024.

The high-yield spectrum’s double-digit rate would represent the worst default rates since 2008, mirroring the peak default rates of double-digits that occurred in the wake of prior recessions (2001/2002 and early 1990s).

Graphic: Deutsche bank chart on default rate history – https://fingfx.thomsonreuters.com/gfx/mkt/zjvqkgzznvx/One.PNG

Graphic: US and Europe high-yield bond spreads – https://fingfx.thomsonreuters.com/gfx/mkt/myvmnwllxpr/Two.PNG

DOUBLE DIGITAL DEFAULTS

They expect that aggregate junk spreads on Treasuries will double to 850 basis point by next year.

More information is available in the related sections. Companies with BB ratings that are just below investment-grade default rates will peak at 2%. However, default rates for single B ratings could reach 11%. Similarly, defaults for highly speculative CCC rating firms could climb to as high as 45%.

Because BB names account for a greater proportion of European junk bonds indexes’ weightings, default rates in Europe are projected to be at 6.6%.

Based on historical comparisons, Deutsche strategists believe that the markets simply aren’t priced for such a scenario. If 40% of the original investment could be recouped after default, the high-yield spreads today would not cover the defaults that have been observed over six discrete default cycles starting in the 1980s.

They see a “tug-of war” between term premia rising and real yields. This is a result of governments wanting to stop the ‘debtsupercycle’ being exposed. They believe the former will take longer to manifest in light of inflation issues and be more selective about areas like the periphery of the eurozone.

Reid writes that this tension means the end of the two-decade-old period of low inflation. Long business cycles, high profit margins. Guaranteed and immediate central bank intervention.

Deutsche’s views on defaults are dependent on minority opinion forecasts, but it is also true that investors tend to be more open-minded about junk bonds due to their benign assumptions of the environment.

Pictet Asset Management’s five-year “Secular Outlook” on global investments, released this week dismissed any talk of long-term structural changes in the world. Instead they advocate a regime of stagnant growth and high inflation similar to that of the 1970s.

They are seeing economic growth and inflation return to their averages over the last 10-15 years. This is due to supply shocks and the pandemic. Mega trends such as savings gluts or weak productivity growth that haven’t changed enough to sustain real yields.

Pictet AM Chief Strategist Luca Paolini stated that as long as the real interest rate is not higher, it’s difficult to imagine a structural rise in default rates. He also said that more ‘zombification’ of companies surviving on low credit would be a greater problem.

It was a stiff wind for others, rather than a hurricane.

It remains to be determined if long-range forecasts for investment are better than meteorological counterparts.

Graphic: US High Yield And Investment Grade ETFs – https://fingfx.thomsonreuters.com/gfx/mkt/gkvlgzyyqpb/Three.PNG

The editor-at-large of finance and markets for Reuters News is the author. These views are solely his.

(by Mike Dolan. Twitter (NYSE:).: @reutersMikeD. Editing by Mark Potter