In their base case(1), Moody’s Investors Service analysts, led by Sharon Ou, expect default rates to continue to rise from here, but remain below the 39-year historical average through August 2023 at least. the lowest level on record earlier in the year and rose only slightly. Credit spread explosions tend to happen when large-scale bankruptcies are actually on the doorstep of the economy, not in anticipation of events that may occur nearly a year from now.(2)
In this sense, the corporate bond market finds itself in much the same no-man’s land as the rest of the US economy. Expectations of an impending recession have yet to be offset by near-record unemployment and manageable debt service ratios. And the American consumer, the engine of the American economy, still appears resilient, which should support growth and corporate profits.
What is less clear is whether these benefits will fully mitigate the impact of a recession; delay the recession for a few quarters; or, on the other hand, spur Federal Reserve Chairman Jerome Powell into stubbornness, pushing interest rates higher and higher to curb the worst inflation in 40 years. After all, monetary policy usually works by intentionally restraining demand, so any resilience can simply be met by a stronger central bank response.
Obviously, the same facts can result in very different predictions, and many investors find themselves trying to strike a balance. The median projection from a Bloomberg survey of economists still shows an equal chance of the US entering a recession in the next 12 months, and those odds have remained constant since August, despite the sharp deterioration in market sentiment that happened in the meantime.
If you agree that a short-term recession is essentially a toss-up, market pricing of credit risk seems surprisingly reasonable. As I wrote last month, a fairly shallow recession would likely mean an 800 basis point option-adjusted spread on US high-yield debt, while a non-recessive bullish case could narrow the spread. at 325 points. Assuming a 50% probability of a recession for economists, it seemed reasonable to divide the difference and plot a fair value gap of around 563 basis points for now. At the current 548 basis points, the market is exactly in that general vicinity.
Could spreads rebound in this range in the short term? Certainly. Spreads will continue to follow equity market volatility, which in turn will be fueled by macroeconomic tea leaves and statements from central bankers. Traders will pick a direction at some point as the facts on the ground change more concretely, but it doesn’t sound crazy at the moment, far from it.
Needless to say, none of this negates the bear case. Credit markets have also changed dramatically since the financial crisis, and it is conceivable that the real signs of distress lurk in more opaque private credit markets. But when it comes to high-yield bonds, it looks like investors can stop criticizing the market(3) so much for its indifference to the risk of recession. That may have been true earlier in the year, but current prices hardly seem that far off the mark. The bears may still have their “I told you so” moment, but they will likely wait a while.
More from Bloomberg Opinion:
• The moral case for higher interest rates: Ramesh Ponnuru
• Bond markets near painful inflection point: Mark Gilbert
• Junk dealers should check with economists: Jonathan Levin
(1) The baseline scenario from their September 19 “August 2022 Default Report” assumes that US unemployment will reach 4.1% by August 2023. Under their moderately pessimistic scenarios and severely pessimistic, Moody’s has peak unemployment and speculative global default over 12 months. rate well above the 1983-2021 average, potentially surpassing that benchmark by the end of this year.
(2) Admittedly, the situation could deteriorate faster than that if something “breaks” and the slow deceleration of the economy accelerates until it collapses. It’s unclear what could break, but the bears have many risks to report, including war in Ukraine and cooling demand from China and Europe.
(3) I was definitely one of the critics in August after spreads narrowed to just 407 basis points.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Jonathan Levin has worked as a Bloomberg reporter in Latin America and the United States, covering finance, markets, and mergers and acquisitions. Most recently, he served as the company’s Miami office manager. He holds the CFA charter.
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