Friday, June 12, 2009

Debt and Defaults

From Zero Hedge comes an interesting post and chart that represents a follow-up to various research that the recent very high risk premia on high yield bonds is likely to be followed by a severe default cycle:
Corporate Leverage At Unsustainable Level
Posted by Tyler Durden
Using the
Fed's Flow of Funds (Z.1) report allows readers to calculate overall corporate leverage: a quick and dirty proxy for a top down leverage analysis. Much in the same way that corporate leverage is derived, the Z.1 provides the data needed to calculate the ratio of net debt to LTM internal funds/adjusted after-tax profits. This is a holistic number that does not stratify based on credit quality so IG and HY get commingled in this calculation (thus keeping it simplified and allowing historical apples to apples comparisons).
Q1 corporate leverage was 1.34x, unchanged from Q4 2008, a level higher than at any point over the past quarter of a century. Comparable prior peaks have lead the HY default rate by on average 9 months in 90-91 and 01-02, implying an expected peak of corporate defaults in early 2010. What is a bigger threat is that once all the external benefits from assistance and stimulus programs wears off, the "peak" could end up being merely a blip in an accelerating upward trajectory. As Bank Of America points out: "we remain concerned that we can be witnessing a temporary stabilization in this ratio, similar to the highlighted 1989 episode, which can then take us to the second leg of deterioration to new highs. In this case default cycle is likely to be pushed well into the future, with an uncertain peak levels. Performance of this ratio over the next few quarters would be crucial in answering this question."
The above goes along with the theme repeated over and over at Econblog Review, which is that despite deleveraging by consumers, the massive deficits being run by the Federal Government have kept overall debt levels in the economy at record levels and probably rising a bit. Risk remains very high, given such principles as reversion to the mean.
Copyright (C) Long Lake LLC 2009

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