Monthly Default Rates

Yesterday, Moody’s published its monthly default study for January. Globally there were a total of 7 rated defaults in the month; 6 in the US (including Eastman Kodak) and one in Europe - Petroplus the oil refiner, whose default has helped push pump prices higher across the South of England in the last two weeks.

Overall, the trailing 12 month rate came in globally at 2%, which is up marginally from Decembers 1.8%. In Europe, the rate was unchanged from December’s revised level of 3%, however a year ago the European level was just 2.3%. So, as expected, this stat is ticking up slowly.

Whilst Moody’s base case is for this rate to gradually rise this year due to the worsening economic outlook, we think it is also worth noting that this figure does have a risk of overshooting due to a squeeze in bank lending.

Banks will typically work with their borrowers during their times of stress in order for them to turn businesses around and repay them in whole. The track record of this forbearance is, in many cases, quite impressive and banks have to be commended for this. However, when banks’ own liquidity and capital is being tested, it is natural for them to look after themselves first and their customers second.

The liquidity injections from the ECB through its Long Term Repo Operations (LTRO) have gone a long way to solving the liquidity problems.  However, capital goes hand in hand with liquidity. Certain types of lending (such as lending to governments) cost banks very little capital, whereas lending to risky or troubled companies is very capital intensive.  With banks only having until June 30th to attain core tier 1 ratios of at least 9%, they have been in capital preservation or raising mode. With their equity still trading at big discounts to book value, raising new equity is just not viable and so they have had to raise capital through balance sheet reduction, or a reduction in “expensive lending”.

In summary, at the margin, banks that are tight on capital are now less able than they would like to be to work with their clients in distress, and this may result in default rates in Europe creeping higher faster than would normally be expected.  Had the EBA 9% rule not been introduced when it was, Mr Draghi’s LTRO masterstroke would most likely have enabled banks to buy more risky assets.  However, as it has happened, banks have so far focussed primarily on their least capital intensive assets – which is not a bad thing as this has enabled the sharp recovery in Italian and Spanish bond yields.

This is a small concern, but at current yields we continue to think that investors are being more than compensated for taking high yield bond risk.

The Itraxx Crossover Index is still over 150bp higher than the average in the first 6 months of last year - which in price terms is about 6%.  For those who like statistics, at a spread of 550bp, the index is predicting that 36.3% of the borrowers in the 50 name index will default within 5 years.  We think this is unrealistic and the actual number will be considerably lower.

We therefore remain constructive on high yield despite the recent rally.  However, we note that for the rally to continue the market will need a successful outcome to the current Greek standoff.