By my definition, benign credit cycles are periods when most if not all four aspects of the market are incentivizing major growth in the supply and demand for credit. That means three or more of the following:
Low and below-average default rates
High and above-average recovery rates on actual defaults
Low and below-average yields and spreads required from issuers by investors
Highly liquid markets in which the riskiest credits can issue considerable debt at low interest rates
At the midpoint of 2019, all four signals indicate we are still in a benign credit cycle, one that, assuming 2016 was an energy industry anomaly, has just finished its 10thyear. That’s the longest by far of any benign cycle in the history of modern finance.
Nonetheless, I am concerned that the bubble in credit markets has achieved new momentum.
Benign credit cycles from the recent past, as Figure 1 demonstrates, have well-below-average default rates, high recovery rates, low interest rate spreads, and high liquidity. They tend to be much shorter than the current 10-year cycle averaging between 4 and 7 years. Since the modern high-yield bond market began in the late 1970s, the average benign cycle has lasted about six years.
Also, once such a cycle ends, the subsequent spike in high-yield bond default rates and decline in recovery rates have been dramatic, with default rates reaching at least 10% for one or two years and recovery rates dropping below 40% and sometimes even below 30%.
The weighted-average dollar-denominated high-yield bond default rate from 1971 to 2018 is 3.27%, with a standard deviation of 3.1%. For the first half of 2019, the rate is 1.1%. Recovery rates — the weighted-average prices of defaulted bonds just after default — were 52.1% in 2018 and 48.8% for the first six months of 2019. These are much higher than the 39% historical weighted average on high-yield corporate bonds.
Recessions accompanied the three recent spikes in default rates to 10% or above. Though timing recessions is challenging at best, the confluence of a stressed credit cycle with recession is a “perfect storm” that has occurred before and will likely occur again. The difficult question is, when? But in the next downturn, default rates will increase to very high levels and defaults to very high dollar amounts. While the catalyst of a credit market crisis is hard to spot, it could be as simple as a major stock market correction or a significant decline in economic growth in a systemically important country or region — say, the United States or China. Indeed, the increase in yield spreads and negative and volatile returns early in 2016 and again in the final quarter of 2018 corresponded with concerns about China and the United States and lower oil prices. There is also now clearly high correlation between high-yield bond returns and the stock market, with the correlation rising well above 70% since 2008–2009.