Distressed Debt Levels Are Very Disconnected from Default Activity – That’s a First

The prevailing narrative in leveraged credit markets so far this year goes something like this: A recession has been averted, quantitative tightening (“QT”) policies didn’t crash the economy, and the Fed is landing the plane. Capital is plentiful, yields are still attractive for lenders and credit markets are wide open, so there’s money available for all but the most desperate borrowers. The worst impact of tight money policies on the leveraged corporate sector is behind us, interest rates are poised to fall and restructuring activity is subsiding and will continue to do so. A persuasive bit of evidence cited in this narrative is falling levels of distressed debt, which would signal credit markets’ optimism about business conditions ahead for the leveraged corporate sector. To all of this we say: Not so fast.

Distressed debt is not a universally defined term but is widely understood to be a corporate debt security or instrument whose market yield (lower of yield-to-maturity or yield-to-worst) exceeds the yield on a comparable Treasury security by more than 1000 basis points (bps). The distressed debt ratio is the percentage of all corporate speculative-grade securities with market yields that are considered distressed. The distress ratio changes daily as market prices and yields change, but generally it is reported monthly by the rating agencies and other credit-related publications. Its long-term average since 1990 is approximately 12% per S&P, but it can vary significantly from that average during periods of high market stress or calm, notably with huge spikes during crisis moments. Currently the U.S. distressed debt ratio hovers around 6.0%, its lowest level since QT went aggressive in mid-2022 and about one-half of its long-term average.

Market pundits have long believed that the distressed debt ratio is an indicator of future default activity because markets anticipate notable changes in default trends several months before they materialize. Logically this makes sense, because markets can react to significant events immediately while the resultant impact from those events in the form of corporate debt defaults can take months to occur. For instance, the distress ratio shot higher in March 2020 when the parabolic spread of the COVID-19 virus caused many states to impose near-lockdown conditions, but the impact of stay-at-home living conditions on corporate performance and default events didn’t fully manifest until a few months later. This time lag effect between the distress ratio and ensuing default activity is especially evident around shock events when credit market movements are sudden and dramatic, such as during the COVID-19 pandemic and the September 2008 global financial crisis (Figure 1) when the distress ratio surged before the debt defaults and bankruptcies piled up.

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