Averages Are Not Your Friend.

Recently, I re-promoted our November 2021 report, presciently flagging the default-dwarfing losses from interest rate rises - completely independent of the credit risks which we capture in our ratings.

I say presciently. It was itself an update of a warning we started sending way back in 2012, so - a warning which took a while to come to fruition.

Are there any other long-standing warnings hiding in plain sight??

The main warning would be the natural extension of the hunt for yield which prompted this year's massive market losses – a warning that, while the lesser evil, credit losses have under-shot their historical pattern for some time.

Default volumes remain modest, but won't stay that way forever. As you look for default risks under different scenarios, it's worth having a sense of relative scale and volatility when you look at the rated universe.

We stick to consistent guidelines on debt burden, liquidity, capital and cash flow generation when we assign our ratings.?That means that the ratings don’t ‘chase’ exact predictions of default likelihood, but they do show a consistent relationship to underlying vulnerability.?

To put numbers to how much more volatile ratings would be if we did chase percentage default predictions - and understand how much actual default rates shift from year-to-year - some data is helpful.

Take a look at the average annual default rate for the speculative grade categories, compared to the actual annual rates in each year, for the thirty years since 1990.

As a distribution, it’s hard to get more bar-belled.?In recent years, we haven’t seen the kinds of peaks at 'BB' and 'B' that fed the long-run average.?But the underlying vulnerability - the risks embedded in our credit ratings - hasn't changed.

What does that mean for the lowest-rated market we cover – HY bonds and leveraged loans, which fall into these three rating categories, and tend to provide the highest volume of defaults?

One way of thinking about that is another chart I’ve used before – the ‘missing defaults’ computation.?If you take a stylized measure of the average default experience, and map that to current HY and leveraged loan markets, you can generate a (purely theoretical) implied default volume. In other words, the amount of defaults you'd see if defaults more or less matched the orange line in the charts above.

By now, it's hopefully obvious that taking a theoretical average default rate doesn’t give you a good picture of what will happen in any given year.?But, in terms of a warning, it does put an order of magnitude around troughs - and peaks.

Looking at the ‘missing defaults’, you can see a gap-to-implied of over $70bn for 2022. That's the gap between the defaults we project to actually see this year (and we have a pretty good feel at this point), and the far higher 'rating-implied' defaults.?On a reversion-to-peak, that gap could obviously widen further.

For what it’s worth, our in-house team dedicated to projecting actual near-term default rates, using a bottom-up process, project the US loan default rate finishing 2023 at 2.0%-3.0%, edging higher in 2024, to 3.0%-4.0%, compared to 4% on a rating-implied basis for the current market.?For USHY bonds we expect slightly higher 2023 figures at 2.5%-3.5%, and again 3.0%-4.0% in 2024, moving above the 3% suggested on a rating-implied basis.

What we describe as Market Concern bonds – those with a mixture of ratings, pricing and newsflow suggesting particular exposure to near-term default, which act as the feedstock of our default projections – are also rising in both the US and Europe.?The Market Concern list for loans is also rising in the US, up more than 30% on 1Q22, and is back at end-2020 levels.

So, with defaults on the rise, when you are modelling possible credit losses under different scenarios in your own book, one other long-standing warning from our ratings is - beware false comfort from historical averages...

Our historical default information is available for the most recent year here, and for prior years here.

For more colour on our projected default expectations, including name-by-name Market Concern lists, historical patterns, and a split between US and Yankee default rates, see our latest work on US loans and US bonds, and European HY and European leveraged loans.

October 2022