Real, or a misleading mirage…?

Among those who are focused on the world of underwriting credit risk, one of the most analyzed and discussed factors is naturally the likely future trajectory and range of probabilities of default within and across industry sectors.

By now, there are several time series, such as the S&P or Moody’s Annual Default Studies, or (in the US) those based upon one of the main high-yield (HY) bond indices, such as that compiled by Bank of America which provide historical data as the basis for trying to forecast future trends.

Most of the “action” occurs in the HY space. Investment grade “gap to default” is quite rare.

At the onset of the pandemic in March 2020, many broad default predictions (based upon past crises) over a 1-year forward time horizon, were in the 7-8% range, and even higher in certain industry sectors- levels not anticipated or experienced since the Great Financial Crisis (GFC).

Yet here we are over one year on and the expected avalanche of major corporate and SME defaults has simply not happened. Even in the upstream energy space, while disproportionately high at over 20%, the ratio has begun to fall, as oil and natural gas prices recover from unsustainable, post-pandemic lows. In fact, the US HY (ex-energy) default index is now down to 1.6% (according to CreditSights) on an issuer-weighted basis, some 3.3% below its 20-year average and approaching all-time lows.

The reasons are the subject of much debate. So, what is going on? Clearly, direct US federal government fiscal support for both businesses and individuals, coupled with that for capital markets from the Federal Reserve, has been a significant factor. In addition, some industries have simply benefitted from the changes in patterns and levels of demand caused by the pandemic; while managers have been forced to adapt to survive, having had to “move ten years in three months”.

As the US economy rebounds, all this leads to the question: “What could now possibly go wrong?”

To which the answer is: “Plenty”

Of course, that does not mean that it will; just that the factors for potential dislocation and negative outcomes certainly exist: the Delta-variant overwhelming less-vaccinated societies and leading to further severe lockdowns; misjudged tapering or withdrawal of fiscal and monetary support; a dislocating change in inflation expectations; swift “China de-coupling”; or unanticipated and severe supply chain disruptions….

Thus, one has to balance proper caution with a continuing assessment of correlations; probabilities; and potential tail distributions. The real art lies in avoiding the “fat tails” and the risk of ruin by continuing to build a diversified portfolio of exposures, and distinguishing between cyclical, survivable stresses and those which are secular and existential.

It is all too easy to accept “conventional wisdom”, and fail to exercise independent, evidence-based judgement.

At Awbury, while we are institutionally paranoid, we also understand that, even when risk seems to be “all around”, one can find opportunities that offer sound risk/reward outcomes when properly understood and structured. The reverse is also true: when everything seems “fine”, it usually turns out not to be, which means avoiding what seems to be “easy money”.

The Awbury Team

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