Corporate America has taken on a record $9 trillion in debt, and investors are wondering if defaults will soar come the next recession. Well, fear not, says Joseph Lavorgna, the chief economist for the Americas at Nataxis.
Reason: When interest rates are low, so are defaults, according to his research. Usually, companies, especially those below investment-grade, have trouble servicing their debt when an economic slump shreds their revenues.
When the yield of a 10-year Treasury is below the rate of GDP growth, meaning rates are low, junk-rated corporate defaults averaged only 3.4% from 1980 to 2009, he found. But when the 10-year’s yield exceeded the economic expansion rate (and thus rates were high), defaults shot up to an average 5.2%.
That is, low rates allow companies to better weather the storm. If they need to refinance, debt service doesn’t suddenly spike. The Federal Reserve reduced short-term rates last month for the first time in 10 years. While the Fed’s actions don’t affect corporate yields directly, overall lower rates eventually move their rates down.
As Lavorgna wrote in a research note, “absent a deep recession, the likelihood of a full-blown default cycle would be relatively low.” Once the recession appears—economists put it anytime next year or 2021—already-ailing sectors like energy and retail would be hit the hardest, he said.
Right now, the credit picture isn’t as downbeat as the enormous debt load would make it appear. This year, by the count of Moody’s Analytics, the number of promotions from junk status to investment-grade (20) outnumber demotions to high-yield territory (12).
And the 12-month trailing default rate for junk, as of June, was 3.9%. Moody’s projects that it will diminish to 2.9% by mid-2020.
Certainly, that’s a lot better than during the last two recessions. The worst during the Great Recession, by Fitch Ratings’ tally, was 13.7% in 2009 and during the dot-com bust downturn it was 16.4% in 2002.