Spreads and future default rates

Current valuations are synonymous with default rates in excess of those seen in all recent times of recession except for the systemic challenge that was associated with the global financial crisis some ten years ago. We believe that given the ING base case economic scenario containing a bounce back in economic activity in 3Q, spreads are more than fairly valued and we would be cautiously optimistic from here.

Framing credit spreads at times of turmoil is never an easy exercise but looking back at default rate levels, the depth of the economic downturn and the accompanying spreads will give us some guidance where spreads could or should be trending from here.

In general spread levels are much lower compared to the Global Financial Crisis peak in 2008, the notable exception is the energy sector and natural resources. Indeed, we expect default rates to exceed other sector peak default rates seen in previous crisis periods as oil and commodity pricing translates into business models where corporates have reduced covenants during restructuring in previous heavy oil price declines (late 2015).

• Telecoms, during the dot-com bubble peaked at a substantial 24% default rate in 2002, but only 7% in 2008, currently spreads are tighter than in the previous crises which we expect will translate to a default rate in single digit territory.

• Healthcare/Chemicals’ spreads have fallen in the middle of the previous crisis, which means the default rates may likely fall between 1.9% and 2.6%. However, we feel that given the nature of this crisis this seems overstated.

• Building products and construction see spreads in excess of 2002 whilst activity continues.

• Utility spreads are one of the few at lower levels than both previous peaks but historical default rates indicate that rating migration rather than defaults itself are more of the concern here.

• Spreads on aerospace, automotive and cap goods seem somewhat low to us compared to 2008 levels and current sector incapacity.

We do expect a rise in default rates, as poor earnings and liquidity issues and of course rating migrations add more default risk. However, as this is not a systematic crisis we do not expect defaults to rise to the c.13% levels seen in the global financial crisis.