The Debt Market’s Calmer Selloff – Jonathan Rochford
While the selloff in growth stocks and tech stocks has grabbed the headlines this year, a calmer selloff has occurred in debt markets. Investors seeking the higher yields offered on emerging market debt, high-yield bonds and long-term debt have also been burned this year. Losses so far have been driven by a repricing of base rate components (fixed rate debt only) and credit spreads, with defaults remaining very low. However, as central banks continue to raise overnight rates and the flood of liquidity induced by quantitative easing dries up, defaults are expected to rise among corporate, retail and government borrowers.
The most obvious part of the debt sell-off was long-term debt, as expectations of further central bank rate hikes materialized. A standout example is the Austrian Bond of the Century, which fell from $235 in December 2020 to less than $100 this month. The most common examples are double-digit losses on US and Australian 10-year government bonds year-to-date. These returns would be particularly bad for risk parity investors, who often increase their bond holdings, assuming that bonds and stocks will show opposite price movements.
Global high-yield debt has suffered the double blow of higher base rates and higher credit spreads this year. The chart below, taken from the St Louis Fed’s FRED Effective Yield Database for US High Yield Debt, shows a surge in forward-looking yield. Defaults remain near historic lows, but this is expected to change significantly over the medium term as weaker borrowers are unable to sell new debt or run out of cash. The fall in new issues and the growing number of suspended and reassessed deals show that lenders have become much more circumspect this year.
Emerging market debt suffered from the added factor of a stronger US dollar, as well as higher base rates and higher credit spreads. The war in Ukraine has caused Russia, Belarus and Ukraine to soar in debt, with US sanctions expected to lead to a default on Russian debt in the coming months. Sri Lanka has just defaulted, with Pakistan, Tajikistan and Tunisia seeing a significant increase in their default risk pricing this year. Argentina’s inflation rate is over 50% and another default is expected in the medium term following their 2020 default and debt restructuring. Chinese developers are dropping like flies with another major developer defaulting this month.
In Australia, the situation was relatively calm, with defaults coming mainly from the construction and real estate sector, as rising costs for supplies and labor exceeded the notoriously thin margins on contracts. of construction. Increased debt collection activities by the ATO are expected to lead to an increase in bankruptcies, although these will affect almost all small businesses with debts limited to their employees, trade creditors and the ATO. The risk appetite of the big banks has reduced considerably since the financial crisis. Australian banks are therefore unlikely to see many large-scale corporate insolvencies like ABC Learning, Allco, Babcock and Brown and Centro that did not survive the last downturn.
While there have been noticeably higher spreads on Australian bank debt and securitization debt this year, listed bank hybrids have moved relatively less. These now pay only a small premium over the much lower risk Tier 2 debt of the same banks. The comparison with securitization is more striking; the average spread on large bank hybrids is lower than some of the A-rated new issues, with some arguably lower-risk BB-rated tranches paying double the credit spread. This mispricing is mainly due to retail investors being unaware of spread changes in adjacent securities which are limited to wholesale investors.