URTH - Brace for a wave of defaults coming soon Deutsche Bank says

2023-05-31 12:07:29 ET

While attention has been centered on the remote but disastrous possibility of the U.S. defaulting on its debt, investors may want to focus more on company bonds, according to Deutsche Bank.

The cycle of boom and bust is returning in 2023 and corporate defaults will become more normal compared with the last 20 years, strategists Jim Reid and Steve Caprio wrote in DB's 25th annual default study.

"Our cycle indicators signal a default wave is imminent," Reid wrote. "The tightest Fed and ECB policy in 15 years is colliding with high leverage built upon stretched margins. And tactically, our US credit cycle gauge is producing its highest non-pandemic warning signal to investors, since before the GFC."

Defaults for U.S. high-yield debt ( NYSEARCA: JNK ) ( NYSEARCA: HYG ) should peak at 9% in Q4 2024, the study says. The high-yield default rate was just 0.5% in 2021 and 1.3% in 2022, according to Fitch, which just boosted its 2023 forecast to 4.5% to 5%.

"The magnitude and length of this cycle could surprise," Reid said. "Although our forecasts just presume a return of the Boom Bust cycle, not a GFC-style shock."

"We suspect the next recession will be the first since the US tech bubble to inflict more pain on credit markets than the real economy," he added. "Corporate leverage is elevated. And global credit markets derive more of their revenue from manufacturing & the sale of physical goods than the real economy at large."

"Going forward, corporates will likely lose pricing power on their sale of physical goods, due to high inventory builds and a post COVID demand shift from goods to services. But labor costs are likely to remain sticky, because of a shrinking working-age population and a desire for consumers to recoup nearly 2 years of negative real wage growth."

That scenario will pressure margins and prevent central banks from riding to the rescue with QE. A shallow GDP trough, with high leverage and less policy support could lead to a "substantial decoupling" between credit markets and the real economy, Reid noted.

What could that mean for stocks?

Junk bonds have a historical correlation of 0.61 to the S&P 500 ( SP500 ) ( SPY ) ( IVV ) ( VOO ) and 0.6 to the MSCI World Index ( URTH ), stronger than their correlation to the overall bond market, according to Alliance Bernstein.

Earlier this year, SA contributor Ivan Martchev called attention to the "surreal correlation" between junk bonds and stocks, noting one veteran bond trader says a junk bond " reads like a bond but trades like stock ."

More on the credit markets

• Inflation Blues And Bond Moves: Riding The Treasury Wave With TBT
• SJB: This ETF Has Won Big At HYG's Expense, And Will Again
• Bond Funds Or Individual Bonds: Which Is The Better Investment?

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