Why Junk Bond Default Rates Will Go Higher In 2016

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Summary

The junk bond default rate edged higher in June.

Junk bond defaults will go higher throughout the rest of the year.

Commodity prices won't recover, and investor uncertainty will make it difficult for indebted borrowers to raise capital.

In the latest sign that stock valuations are out of touch with economic reality, Moody's reported that the global default rate for junk bonds (NYSEARCA:HYG) climbed to 4.7% in July (up from 4.6% in June, and 50 basis points above the long-term average). US stocks (NYSEARCA:SPY) are at record highs, but junk bond default rates for US companies are even higher than global levels: in July that default rate climbed from 5.2% to 5.5%, and analysts speculate that it will reach 6.3% before the end of the year, led by a 10% default rate in metals and mining, and a 7.2% default rate in oil & gas.

Weakness in the commodity sectors is responsible for the historically high default rates, and there is little indication that things will get better anytime soon. According to Fitch Ratings, the TTM default rate for junk bonds hit a six-year high in June, and the value of defaults reached $50.2 billion in the first six months of the year (compared to $48.3 billion for all of 2015). Energy companies defaulted on $28.8 billion (60%) of this debt, which equates to a sector-wide default rate of 15% (led by exploration and production at 29%). Even though commodities have rebounded throughout the year, prices are still too low for producers to earn enough to meet their obligations (keep in mind that companies loaded up on debt when energy prices were near $100). Fitch predicts the value of defaults will reach $90 billion by the end of the year (a 40% increase over last year's total), and we also think default rates will increase.

Global economic growth is slowing rather than increasing, and we expect gluts in the commodities industries, from metals and mining to oil & gas, to persist throughout the year. Record crude and refined product inventories will prevent oil prices from recovering, even if energy producers continue to curtail production levels. End-market demand is simply not strong enough, and there are signs that economic conditions could get worse. The US auto sector appears to be slowing down, and the aircraft cycle is peaking. With refiners unable to find enough buyers for their bulging refined product inventories, they will likely swallow huge discounts just to unload the excess. Furthermore, the rebalancing in China away from heavy industry to consumption will continue to weigh not only on energy demand, but also the prices for minerals and metals used to build construction and infrastructure. We simply don't see a path to recovery in commodity prices over the next six months.

If prices don't recover, companies won't be able to prevent default through internal operations, which means they will have to tap the financial markets for additional liquidity if they wish to prevent default. The problem is that investor appetite for junk bonds is not there. Global macro weakness and Brexit have made investors more uncertain and has driven demand for safe-haven assets. Even though the Fed will keep interest rates low for the rest of the year, this will not catalyze a return to junk bonds, as we believe yield-hungry investors will instead put their cash in emerging markets, much like they did immediately after Brexit, when it became more obvious that the Fed wasn't about to raise rates. Junk bond issuance is 33% lower than last year at this time, and until macro conditions improve, it will remain very costly for indebted firms to borrow.

Conclusion

Junk bond defaults ticked higher in July, led by borrowers in the commodity sectors. The consensus is that defaults will continue throughout the year, and that default rates will edge higher as well. We agree, as underlying macroeconomic fundamentals aren't showing any signs of improvement, and widespread investor uncertainty will continue to make it difficult for borrowers to meet their obligations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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