Credit Losses - Still Not The Worst Threat to 2022

2022 has got off to a boisterous start. Our 2022 Horizons report highlighted the key risks which could have the most impact on our rated portfolio in the coming two years, and picked out the rising rate cycle as our top concern.

Many sectors are untested in a secular rising rate environment for the key dollar financing market.?Credit losses are a much lower risk to investors than market losses in a rising interest rate cycle, as our bond shock analysis underlined.

Interest rate rises will have a positive impact in some areas (e.g. spread products for banks), but contagion risks to other asset prices and economic sentiment pose real risks. Effects from both 'risk-off' refinancing risk and a stronger US dollar pose risks for lower-rated entities, a supportive environment for floating rate leveraged loans notwithstanding. Maturity walls and free cash flows for the most exposed sectors are reasonably robust, but story credits and sectors always retain exposure to the market's mood-swings. A stronger US dollar inevitably also spells pain for emerging market ratings.

Bond Shock – Top Systemic Concern

But investment grade investors will also be paying more attention to interest rate risk than credit risk, for good reason, given the scope for losses to enter bond shock territory. Fitch’s analysis of a stylised ‘BBB’ US corporate bond illustrates that even a moderate interest rate increase can result in market value losses far exceeding credit losses in even a severe default risk scenario.

Potential market losses in dollar terms have increased significantly since our last analysis in 2011, driven by the surge in corporate bond issuance, duration extension and the increase in ‘BBB’ category bonds. Even with the greater skew down the credit spectrum, credit losses are the lesser part of the story.

In our stylised market stress analysis for a well-diversified portfolio of ‘BBB’ corporate bonds, the highest average annual default rate for ‘BBB’ non-financial corporates since 1992 was 0.85% (in 2002). Assuming a 60% loss severity, the annualized average credit loss would be 0.60% under this scenario, well below the 4% market value loss in the 50bp rate rise scenario.

The annual default rate would need to climb to 6.67%, about eight times greater than the ‘worst year’ scenario, to generate the same loss equivalent as the 50bp rise in rates.

And we aren't starting from a position that close to 'worst year' default rates. 2021 saw the US HYB and US leveraged loan markets turn in roughly 20% of the default volumes you would have expected from long-run average default rates, a decade low. We foresee that number rising, but not dramatically, this year.

Many of the missing default billions pictured above were held at bay by the wall of market liquidity which is now on the turn. As bond returns already start to slide, our base case is for most of rated entities in the FI space to resist selloff pressure (e.g. insurance companies, pension funds, short-term funds) and absorb MTM losses (e.g. banks). The policy response will be critical in managing spillover risks of the joint tasks of exiting from QE and resetting the policy rate dial.

Contagion effects of a much wider bond sell-off could tighten financing conditions in a manner that would have much greater implications for credit ratings.

Our simplistic shock analysis obviously uses stylised numbers, holding all other factors stable (which already doesn't sound very 2022), but it does perhaps help orient investors choosing, for now, between credit and duration. With fewer downgrades and low defaults expected this year, credit ratings may recede to become more of a background noise in what promises to be a very active market.

Or - alternatively - a policy mistake could make our current return to pre-pandemic outlook levels very much a fleeting visit. Keep an eye on outlook shifts at fitchratings.com and fitchratings.com/fitch-portfolio-analysis.