A Default Spree Is Coming… And It's Going to Be Ugly

By Michael E. Lewitt, Global Credit Strategist

Junk bonds may be rallying but it has little to do with corporate credit quality, which just keeps deteriorating.

As of the end of August, 113 companies had defaulted on their debt in 2016, already matching the total number of defaults from 2015. The year-to-date default count was also 57% higher than a year earlier.

In case anyone is paying attention (it appears they are not), the last time defaults were this high was in 2009 when 208 companies failed during the financial crisis.

Standard & Poor's is now projecting that the annual default rate will hit 5.6% by June 2017 with 99 junk-rated companies expected to default in the 12 months ending June 2017. That would significantly exceed the 79 U.S. companies that defaulted in the previous 12-month period ending June 2016, which resulted in a 4.3% default rate.

While low oil prices are a major contributor to this ugliness, energy companies only accounted for 57% of the defaults in the 12 month period ending in June 2016.

That means that there is plenty of distress to go around…

The Fed Has Everything to Do With It

Even more disturbing is the fact that defaults are rising rapidly while many leveraged companies continue to enjoy low borrowing costs courtesy of the clueless Federal Reserve.

If interest rates were remotely normalized, the default rate would already be well above 5% and heading to the high single digits. None of this appears to bother investors, who are chasing yield in the rare places they can find it, which is always in all the wrong places.

As a result, the normal spread-widening that occurs when defaults spike is not occurring; which is a very unhealthy phenomenon because it signals high levels of risk-taking and complacency on the part of investors.

The history of the modern junk bond market teaches that most of the returns are earned in compressed periods after the market suffers a sharp sell-off.

The rest of the time, investors are pushing water uphill as they invest in securities that offer poor-to-mediocre risk-adjusted returns until the point when the bottom falls out and they suffer catastrophic losses.

There is good reason why very few credit hedge funds or other large investors made any money in junk since mid-2014, when the market began a sharp sell-off that coincided with the slide in oil prices and the slowdown in China.

This sell-off ended early this year when the market began to rally based on the realization that the Federal Reserve lacks the intellectual capacity to understand the consequences of its own policies or the moral courage to change them.

Why This Yield Chase Is a Bad Idea

And investors are chasing zombies because numerous companies are not generating enough cash flow to reduce their debts or repay them when they mature. Instead they are just living on fumes and waiting for the day of reckoning when their debt matures and they can't pay it back.

More of them will hit the wall when their debt comes due and they can't refinance it at a reasonable interest rate because they are financially weak.

Standard & Poor's is telling us that more of these companies are heading to the bone yard. Investors should be selling rather than buying this risk.

Junk bond market complacency mirrors stock market complacency. The stock market is expensive.

The Shiller Cyclically-Adjusted Price/Earnings Ratio is currently 27x, a level is has only reached before in 1929 and 2000 before crashing to the ground.

For some reason, investors think it is a good idea to chase expensive stocks over a cliff because other asset classes such as bonds offer even worse alternatives. I have news for them – it is not a good idea, it is a terrible idea. Smart investors understand the value of holding cash and avoiding losses and waiting for a better entry point.

Now is the time to be patient and avoid taking unnecessary risks.

The world is a dangerous place. Markets are fragile. Sit tight and wait for opportunities. They will come.

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