Default Peaks May Already Be Behind Us

One of the drivers underpinning our 2021 thesis that credit spreads would end the year tighter than where they started was that the default rate would peak sometime in Q2 and drop quickly thereafter.

In our view, the 12-month trailing global default rate in speculative grade bonds was likely to peak in the US at close to 7% and in Europe it would be maxing out at just under 5%. By year-end, however, we thought the default rate could be back below 5% in the US and below 3% in Europe. Not only would these be incredibly low figures given the economic stress, but also the pace of change implied here would be like nothing we have seen in previous economic cycles. 

One precursor for defaults is what we refer to as negative ratings migration, with companies’ debt being downgraded as their fundamentals deteriorate. The ratio of the number of upgrades to downgrades is a good way to monitor this. Naturally there are quite big disparities by geography, by sector and also by ratings agency, but it is not difficult to build up an overall picture if you follow these figures closely. Having shown around 10 downgrades per upgrade in the second quarter of 2020 as pandemic disruption took hold, this statistic has been incrementally improving, and for those that have been following our outlook, we had forecast that by Q4 2021 we would be experiencing more upgrades than downgrades again in global credit. This would generally be a good fundamental backdrop for credit spread tightening, especially early in the cycle. 

Now as we know, fundamentals have moved quickly and markets even more so with such a strong technical backdrop, but even our most constructive forecasts did not envisage that by Q1 2021 we would already have more upgrades than downgrades in global credit – yet that is where we are. The year has only just begun, but for us the trend in ratings is both clear and global and serves as a reminder for how quickly our environment is changing. 

 In total from these three territories there have been 88 ratings upgrades by Moody’s and 49 downgrades year-to-date. By contrast, it took until Q1 2014 for this ratio to turn positive after the global financial crisis. 

It really is difficult to overstate how quickly fundamentals are changing and how in our view this is a cycle like no other, despite what is likely to be a weak second quarter that may flirt with double dip recession in some parts of the world. 

We think this current pause in the global rally is healthy and gives investors a rare moment to reassess, but from a fixed income credit point of view we would not expect too much of a dip. Much like in September and October last year the technical position should keep credit spreads calm, then as vaccine rollouts progress and lockdown restrictions are eased, this should enable a buoyant recovery in H2 and a fundamentals-driven period of credit spread contraction.