A ‘tsunami’ is about to hit the debt market

A tidal wave may be coming to the bond market, and it’s not going to be pretty.

At least that’s the view of Matthew Mish, credit strategist at UBS. To Mish, the elevated rates of default in the commodity sector and high risk bonds are a harbinger of things to come for the broader debt market.

“First, our quantitative framework is signalling a broader deterioration in the default outlook, with our model projecting default rates of 4.3% over the next 12 months (versus 2.6% one year prior),” wrote Mish in a note to clients on Thursday.

Mish’s research asks whether the recent uptick in default rates is simply a “rogue wave” that will dissipate or the “start of a tidal wave” that will bring the rate of defaults much higher over the long-term.

Tsunami city debt market bonds

Mish is in the latter camp. He cites three short-term reasons for a coming increase in the number of firms unable to pay back their debt. They are:

  1. Decreasing profits: Mish notes that corporate profits fell 7.6% in the first quarter against the same time period a year ago. In order to pay back loans, companies need to continue to make more, and thus with less cash coming in, there will be less to allocate to debt.
    Corporate profits defaul rates financial
  2. Lending standards are getting tighter: Firms also have the ability to pay down debt that is coming to maturity by issuing new debt, effectively kicking the can down the road. Lending conditions for new debt, however, are getting tighter as banks focus on higher quality borrowers. In turn, this makes it tougher for companies to pay for debt with more debt.
  3. Debt is getting more expensive: Loan spreads, or the difference between what banks have to pay to borrow money and what they charge companies in interest on loans they then give out, are starting to widen. In other words, new debt is getting more expensive.

Add these factors up and you’ve got a problem for companies with debt outstanding, and the $1 trillion market for low-grade, risky bonds.

This trouble is not just limited to the commodity space. Mish estimates that the default rate for non-energy firms will creep up to 3.5% in 2016 up from just 1.5% currently.

“Higher frequency data suggest default stress is rising specifically in the media/ entertainment, consumer/service, retail and aerospace/ industrial sectors (as well as the non-bank financials),” wrote Mish.

As these defaults start to pile up, said Mish, long-term shifts in the credit markets could snowball and make the situation even worse.

Increased regulation, the holding of high yield debt by “less stable” investors such as mutual funds which are likely to unload the bonds quickly in the event of a drop, and the increased size of the low-quality leveraged loan market could all make the tidal wave even worse than in the past.