Practical analysis for investment professionals
01 August 2016

Edward Altman: The Benign Credit Cycle Is in Extra Innings

Edward Altman: The Benign Credit Cycle Is in Extra Innings

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Edward Altman says the benign credit cycle is in “extra innings,” but the metaphorical relief pitchers — central bankers — are running out of gas.

Altman reviewed the current states of four credit cycle indicators and his Z-score measure of financial worthiness, in a presentation at the 2016 Financial Analysts Seminar. Altman’s analyses focused on the risky high-yield bond market, where defaults are frequent during credit crunches. Though most indicators point towards the end of the benign cycle, Altman could not predict when the stress cycle will begin.

“At the beginning of this year . . . particularly 11 February, when things turned around, we said we were in the ninth inning, but [the] score was tied,” he said. “Extra innings can last for one inning or it can last for many innings afterwards.”

Default Rate

Few companies issuing high-yield bonds default during benign cycles, whereas default rates are high during stress cycles.

The average annual default rate in dollar terms since 1971: 3.4% (over $100 million liabilities, four quarter moving average). Over the last 12 months: 4.5%. Default rates are above the historic average for the first time in over six years. The longest benign credit cycle since 1972 was seven years, and the average length is five years and six months. Various forecasters have put the default rate for 2016 between 4.4% and 6%, all higher than the historic average, perhaps indicating the beginning of a stress cycle.

Altman acknowledged that 60–65% of defaults are in the oil and gas and mining sectors, but warned against disregarding the data, as there is always an outlier industry.

Recovery Rates

Altman talks about recovery rate in terms of what a distressed investor could buy a bond for immediately after default. The average recovery rate since 1978 is 46% of par value just after default. Through 21 June, the recovery rate in 2016 is under 20%, a historic low. That is down from 63% in 2014 before the recovery rate dipped below 34% in 2015, mostly due to the mining and energy sectors. Based on the recovery rate alone, the benign cycle is already over.

Yield Spreads

Altman also looks at the yield to maturity spreads (YTMS) between high-yield bonds and 10-year US Treasuries as an indicator of the market’s willingness to put money into credit. The average YTMS since 1981: 543 basis points (bps). YTMS last June was 589 bps, indicating that the benign credit cycle was still going. Since reaching a historic high of over 2100 bps in December 2008, YTMS spiked in 2011 and late 2015. In both cases, central banks loosened monetary policy to lower spreads and possibly prolonged the benign cycle.

Liquidity

Altman uses the percentage of new issues rated B- or lower as an indicator of how much the market is willing to spend on very risky debt. This indicator tends to rise throughout the benign cycle before falling sharply.

During the downturn in the fourth quarter of 2015 it appeared as though liquidity was low. B- or lower issues fell from 26% of the market in the third quarter to 2%. Despite the sell-off continuing into the new year, risky bonds are back up to 16% of issues in the first quarter of 2016.

“Last week or last month was the biggest net inflows into the high-yield space ever. And the reason is quite obvious: search for yield. It’s the only place you can get yield these days,” Altman said.

CCC rated bonds alone made up 12% of the dollar value of new issuances last quarter. Between 1971 and 2013, 47% of CCC bonds defaulted within five years after issuance. Altman expects low-rated bond issuances to stay high for the next two quarters as companies perceive a last chance to capitalize on low interest rates.

“Junk is back in style,” he said.

Z-Scores

Altman’s Z-score uses four or five weighted variables to assess the likelihood a firm will go bankrupt. The lower the Z-Score, the less solvent a company, with scores under 1.81 indicating that bankruptcy is likely.

In 2007, the median score for US companies was 1.81, the equivalent of a B rating. The rating in 2014: 1.80. Firms are no more credit-worthy than they were just before the Great Recession.

Altman predicts the beginning of a stress cycle this year or next. Default rates may or may not exceed 10%, which would almost certainly coincide with a recession.

According to Altman, central bankers’ attempts to prolong the benign cycle with rock-bottom and even negative rates have done more harm than good. Low rates incentivized corporate firms to take amounts of leverage reminiscent of banks in 2007. Moreover, the preoccupation with growth forces fixed-income investors to sacrifice income.

“I think it’s really sad. Folks who have to depend on fixed-income securities . . . they’ve been disadvantaged for so long with these low interest rates all in the name of growth,” Altman said. “Let’s face it, it hasn’t worked. We’ve been growing at 2%.”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: CFA Institute

Video



Key Takeaways

  1. According to Edward Altman, the benign credit cycle is in “extra innings,” but the metaphorical relief pitchers — central bankers — are running out of gas.
  2. The percentage of new issues rated B– or lower can be used as an indicator of how much the market is willing to spend on very risky debt. This indicator tends to rise throughout the benign cycle before falling sharply.
  3. According to Altman, central bankers’ attempts to prolong the benign cycle with rock-bottom and even negative rates have done more harm than good. For example, low rates incentivized corporate firms to take amounts of leverage reminiscent of banks in 2007.

Transcript

Has the Benign Credit Cycle Ended‎ and Is The Credit Bubble Likely to Become Even More Inflated?
Edward I. Altman

View the full transcript (PDF).


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About the Author(s)
Matthew Borin

Matthew Borin was an intern at CFA Institute. He was pursuing a bachelor's degree in economics from Williams College, Williamstown, Massachusetts.

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