The World Ahead 2022
An uptick in corporate defaults is unlikely
But if credit tightens, junk bonds will sour quickly
EUPHEMISMS ABOUND in the market for risky debt. Bonds issued by the companies most likely to default on them are no longer “junk”, but instead “speculative grade” or “high yield”. Borrowers would never dream of stiffing their lenders; some, however, engage in “distressed exchanges” that reduce the value of their debt without lenders’ consent. One especially genteel measure of profitability that emerged during the coronavirus pandemic was “EBITDAC”—earnings before interest, tax, depreciation, amortisation and covid.
During 2021, such politeness seemed to be justified. The global default rate for speculative-grade debt started the year at just under 7%, around half the level it hit during the worst of the financial crisis of 2007-09. Despite waves of lockdowns triggered by successively more contagious strains of coronavirus, it spent the next three quarters in decline. According to forecasts by Moody’s, a credit-rating agency, it will continue to drop in 2022, hitting 1.6% by the end of April before beginning a gradual rise. That is some way below the long-term average of 4.2%.
So far, the calm has been underpinned by huge fiscal and monetary support. Governments have arranged grants and loans for businesses in financial distress, and buoyed consumer spending with furlough schemes and stimulus cheques for individuals. As a result, companies in debt have mostly been able to find the cash to service it. Meanwhile, central banks have kept interest rates low and flooded markets with liquidity via vast expansions of quantitative easing. That has encouraged investors to lend to riskier borrowers from whom they can extract higher interest payments.
Even the riskiest borrowers are likely to enjoy low interest rates and easy access to credit for some time
The net effect is that credit spreads for American junk bonds—the additional interest charged on them in comparison to government debt—are at their lowest since 2007. In Europe, much high-yield debt carries an interest rate below inflation, meaning that in real terms even speculative-grade issuers are being paid to borrow.
For as long as America’s Federal Reserve keeps supporting the market, expect this state of affairs to persist. Although it is about to start reducing its bond purchases, it is unlikely to stop them altogether, or to begin raising rates, before the middle of 2022. That means that even the riskiest borrowers are set to enjoy easy access to credit for some time to come. And companies with the ability to tap new, cheap funding don’t go into default.
Should credit conditions tighten, though—perhaps due to persistent high inflation—debt investors will be in for harder times. Of the $1.7trn-worth of American junk bonds, perhaps $250bn is owed by companies whose earnings over the past year barely covered their interest payments. A decade and more of ever-looser covenants has made it harder for lenders to seize the wheel when borrowers get into financial distress. Capital structures are also more rickety than they used to be, with less junior debt to absorb losses.
Many of those with the worst credit ratings are backed by private-equity funds, which have more of a reputation for financial bait-and-switch than they do for ensuring creditors are paid back in full. The coming year ought to be a benign one for corporate defaults, but if it turns, it will turn quickly.
Joshua Roberts: City and finance correspondent, The Economist■
This article appeared in the Finance section of the print edition of The World Ahead 2022 under the headline “Distress call”