The workings of financial markets never cease to amaze from time to time. Especially when they decide to systematically deny the elephant in the room. Equity investors are often blamed for this behaviour, but high-yield investors can also have some of it at the moment.
If there is anything consensus after the demise of Silicon Valley Bank, it is surely that the outflow of bank deposits is leading to tighter lending requirements. Not least because loan-to-deposit ratios have increased.
Now, lending conditions have already become much less favourable in recent quarters, which is of course largely explained by higher interest rates. And tighter lending conditions mean more defaults. Below is the net percentage of banks that have tightened their loan terms as revealed by the Fed Senior Loan Survey, plotted against the 12-month rolling default rate.
It should come as no surprise when banks turn off the credit tap, bankruptcies skyrocket. Based on the latest figures from the Fed Loan Survey, you can expect a default rate above 6 per cent. By comparison, last year the rate was 1.7 per cent.
Spreads
Whoever says defaults, says high yield. But for now, the asset class itself thinks very differently. The chart below again shows the net percentage of banks tightening loan terms, but now plotted against spreads on US high yield bonds. This is a strong example of looking past the elephant in the room.
Now there are extenuating circumstances, such as that the net interest burden of high yield companies is still low and profits are actually high. But both factors are going to move in the ‹wrong› direction in the coming period. In my view, therefore, spreads on high yield bonds are too low. Apart from the possible spillover effects from the commercial real estate sector. Spreads on Commercial Mortgage Backed Securities have already widened, but high yield investors currently know how to look over that elephant.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week appears every Thursday on Investment Officer Netherlands.