Source: S&P Global Ratings
Edward Altman, Professor of Finance at NY University’s Stern School of Business and a leading authority on the distressed debt market, recently spoke with Financial Sense about the massive surge in global corporate defaults this year (see chart above) and why this could become a problem if, as he believes, we are in the latter innings of the benign credit cycle that started in 2010.
Professor Altman was named as one of the “100 Most Influential People in Finance” by the Treasury & Risk Management magazine in 2005 and is widely known for his development of the Altman Z-Score, which is commonly used to help predict the probability that a firm will go into bankruptcy.
Here’s some of what he had to say on Friday’s podcast:
“Four metrics of the credit cycle are the default rate (and I particularly look at high yield bonds—the more risky debt), the recovery rates when there are defaults and how much the investor actually loses, yields and yields spreads are the third—what is the cost of debt capital for companies raising capital in the leveraged finance market—and, finally, liquidity—how easy is it for companies to raise capital in the debt markets and how liquid are those instruments if and when they want to sell them.
Those are the four metrics—default rates, recovery rates, yields or yield spreads, and liquidity—and all of them back in January-February when we last spoke were pointing in a direction that the benign cycle was just about over. Benign meaning low default rates, high recovery rates, low-interest rates, and a lot of liquidity—that would be the definition of a benign credit cycle—and I used the 7th or 8th inning as the sports metaphor at that time...
To continue the sports metaphor of where we are today, I would say we are at the end of the game, the end of the ninth inning now, but the score is tied and we are in extra innings meaning that the end of the benign cycle or the end of the game is uncertain as to when it will happen and I think that's really where we are now.”
Do you think the stock market is pricing in the state of the credit markets currently, especially when we look at the spike in global corporate defaults?
“Well, I don't think they're pricing in the two metrics that I think are very important: the default rate and the recovery rate. I think they are ignoring it, to be honest with you, because the markets have been very bullish and we’re seeing new record highs for the stock market when these two metrics are pointing toward a more stressed situation...
I really don't think that the stock market is looking at the credit markets in the last few months as they did at the beginning of the year when things really looked grim and I think that's a mistake because the credit markets are still not strong with respect to the outlook. What is strong is the comeback since the beginning of the year and I think that's mainly a function of central bank activity and the price of oil, not the fundamentals in the credit markets. And so, if I was a betting man, I would say that we're just waiting for the next shoe to drop in those three areas—China, US, and oil—and when that happens I think you'll find a reversal not only in the bond markets but also in the stock market…"