Edward Altman doesn't get it: Why have credit spreads on US high-yield bonds returned to below historical averages?
Such yield spreads are meant to be leading indicators of investor uncertainty, and today the spreads suggest that the degree of uncertainty is relatively low. Yield-to-maturity spreads on high yield against 10-year US Treasuries have fallen to an average of 450 basis points, about 75bp below the historical average.
Given the headline issues around Greece's bailouts, US fiscal problems and a potential bubble in Chinese real estate, Altman finds this odd.
As a finance professor at New York University's Stern School of Business, Altman is known for inventing a predictor of corporate defaults called the Z-Score (and for uncorking bottles of champagne every time there's a major corporate default in the US).
About one year ago, at a conference on distressed-asset investing in Hong Kong organised by AsianInvestor and FinanceAsia, Altman had predicted corporate default rates of 13%, a figure he revised downward to 10.4% at our follow-up event in Tokyo in December.
The actual figure for 2009 turned out to be 10.8%.
Today, his one-year forecast for corporate defaults is 3.8%, reflecting a market environment pumped full of stimulus money.
Yet the actual default rates for the first quarter of 2010 have fallen below 1%. "This is just like 2006 and early 2007," Altman says, addressing another audience of investors and distressed specialists at AsianInvestor's and FinanceAsia's latest conference on distressed assets, which began yesterday in Hong Kong and continues today. "But if it's like 2006, then default rates should be much higher. Are things really that much better today?"
He notes that distressed-asset fund managers are focused on refinancing distressed companies rather than ushering them to bankruptcy, but he's sceptical that many of these companies will ultimately survive. Some are simply uncompetitive and need to be restructured, not just refinanced.
"Risk premiums are in decline," says Altman. "We're seeing the real dregs getting refinanced, triple-C-rated companies, just like in 2006."
With interest rates so low, investors are attracted to the yields. Low interest rates are also making it easy for companies below investment grade to issue new bonds. Creditors have little incentive to push for bankruptcies and prefer distressed exchanges for bonds (or taking haircuts on loans), because when credit is hard to get, they can't get debtor or exit financing.
Around 50% of distressed exchanges end up in bankruptcy within a few years, but the recovery rate is about 10% higher than for typical defaults, so creditors tolerate them.
Altman says the current low spreads on junk bonds do not, in his opinion, reflect the maturity schedule of upcoming debt maturities. High yield, commercial asset-backed securities and leveraged loans are due in huge amounts over the next few years, peaking in 2013.
This comes at a time when the US and other governments need to refinance or raise new debt in vast quantities. If the US falls back into recession and consumer confidence is weakened, the confluence of events could prompt big market moves. The European Union bailout for Greece, a three-year package, will also conclude at the peak of US private-sector refinancing.
Given low interest rates and even lower credit spreads on junk, Altman says there is a real risk that another credit bubble is in the making.
High-yield bonds are now selling for par, on average, and are of interest only for their coupons, he says. Distressed debt, which had a fantastic year in 2009, still has value and will serve investors well in 2010. The most value may be in bank loans in default, which on average are cheaper than their historic average prices.
But if default rates trend higher, more towards Altman's prediction of 3.8%, then owners of all these asset classes at current spreads will suffer.
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