Edward Altman, Professor Of Finance & Director Of Fixed Income & Credit Market Research, NYU STERN SCHOOL OF BUSINESS will be presenting his session 'Global Credit Markets: Is It A Bubble?' at this year's SuperReturn U.S. Get a preview of his session by reading his blog and learn why the Credit Bubble may soon burst...
Credit Market Bubble Building?
A Forming Credit Bubble Could Burst by 2017/2018
Edward I. Altman
Bubble theories and concerns are becoming quite common these days for several asset classes, prompting discussions and warnings, including those from federal regulators. This leads to some key questions: Are we in the midst of an inflating credit bubble and, if so, when is it likely to burst? Contrarily, are we experiencing an extended period of opportunistic debt financing?
The evidence we have compiled leads us to conclude that, indeed, a bubble is building; but it is not likely to explode dramatically, with a significant increase in corporate defaults, until at least late 2016 or, more likely, in 2017-2018. Fear, however, of a potential crisis in banking credit and equity markets may contribute to periods of negative price movements in these and other asset classes before the bubble actually bursts. This is consistent with our expectation of a below-average default rate for the next 12-24 months. However, we are becoming quite concerned about the period thereafter, when the current benign credit cycle will reach six or seven years in length, the latter tying a record in modern high-yield bond history.
Benign and Distressed Cycles: How Long Do They Last?
Recent benign credit-cycles, of well-below-average default rate periods have lasted four years (2004-2007) and seven years (1992-1998), with the current cycle now in its sixth year. The average benign credit cycle since 1971 averaged about six years.
Once a benign cycle ends, the subsequent spike in default rates typically reaches at least 10% for one or two years. With the market’s size now significantly larger than during prior default peaks, the amount of defaulted high-yield bonds likely to occur in stressed cycles will be between $150 billion to $200 billion in each 10% default year. We observe the above-average default rates lasted three years in the 1989-1991 period, four years, or so, in the 2000-2003 period and just two years in the 2008-2009 cycle, averaging about three years.
It should be noted that the three recent spikes in default rates to levels of 10% or more were accompanied by economic recessions. Forecasting the timing of economic recessions is challenging, at best, and to estimate the confluence of a stressed credit cycle with recession is a “perfect storm,” but one that has occurred a number of times in the recent past. And it is likely to occur again – predicting the timing remains the difficult issue.
New Issuance and Credit Quality
The corporate HY and Investment Grade (IG) sectors have been refinancing and increasing their debt financing continuously since the current benign cycle started in 2010. Indeed, new HY issuance topped $200 billion for the first time in 2010, reached a peak of $280 billion in 2012 and almost matched that in 2013 and 2014. The growth of new HY issuance in Europe has been even more impressive of late, reaching €92 billion in 2013 and €119 B in 2014. In a nutshell, market acceptance of newly issued high-yield junk bonds has been remarkable, with record amounts issued at relatively low interest rates. This reinforces that a seemingly insatiable appetite exists for higher yields in this low-interest rate environment. New issuance of leveraged loans has also grown dramatically of late, from just $77 billion in 2009 to a record $607 billion in 2013. The amount of new issuance was $530 billion in 2014.
In terms of the bond rating ascribed to new issues, recent trends also indicated deterioration in credit quality, notably the proportion of newly issued bonds rated “CCC” compared to total HY new issuance, from 2005 through the third quarter of 2014.
The second quarter’s CCC proportion jumped to 25.9%, second only to the 2007 record 37.4%, when just about any credit quality company could find new bond financing. Issuance of CCC rated bonds fell in the fourth quarter of 2014 and first quarter of 2015. Still, an average of 22.1% for the first two quarters of 2014 was quite high. Now, two quarters’ results are not enough to proclaim a serious escalation in risk tolerance, but it is still an ominous indication of significant defaults down the road. Our mortality rate statistics show that the average three-year cumulative mortality (default rate for “CCC” new issuance) is about 34% and, by the fifth year, it reaches 47.4%. We need to keep our eye on the results over the next few years of this low-rating cohort, as well as to keep in mind the even more plentiful and still risky “B” rating category.
LBO Statistics and Trends
With respect to highly leveraged LBO financing, we can observe that the purchase-price multiple increased to an incredible 10.9 times in the third-quarter of 2014 and 11.9 times in the first quarter 2015. Again, this is strongly reminiscent of, in fact exceeding, the frothy 2007 multiple. Average total debt/EBITDA has risen to dangerous levels in the United States, the highest since 2007. Skeptics might argue that these high-risk levels are acceptable in this low interest rate environment. However, this can change quickly, especially if the economy falters and the Federal Reserve takes its foot off the accelerator.
Whether this tolerant, highly liquid market sentiment persists and the Fed continues its strong growth posture are topics continuing to warrant prominent analysis.
Edward I. Altman, PhD is the Max L. Heine Professor of Finance and Director of the Credit and Debt Markets Research Program for the Salomon Center of New York University’s Leonard N. Stern School of Business. He famously created the Z-Score bankruptcy prediction formula, first published in 1968.