“The current credit cycle is the longest in history,” says Achilles Risvas of hedge-fund firm Dromeus Capital, writing in Investment & Pensions Europe. Despite that, credit markets are priced as if nothing can go wrong.
US high-yield bonds offer near-record-low premiums to US Treasuries, lenders have relaxed credit standards and the usual flotilla of high-risk instruments, such as payment-in-kind bonds, have re-emerged.
When the cycle turns and defaults start to rise, the fallout is likely to be severe, not just for low-quality bonds and loans, but also in other markets, such as equities and property. However, “exactly what could awaken the bear is uncertain”.
Indeed, calling the turn in the default cycle is extremely difficult, say Oleg Melentyev and Daniel Sorid of Deutsche Bank – even though “it’s arguably the most important call any credit investor can make”.
Valuations, market fundamentals and economic indicators are not reliable; instead, a look back at past credit cycles suggests the key is to spot the “volatility shock”.
A large stock of poor-quality debt can exist for a long time – as it does today – before a clearly identifiable trigger event causes investors to reassess their appetite for risk, “driving lenders away from extending credit to the weakest issuers and leading to an increase in defaults”.
Predicting what will bring about this shift in investor psychology is obviously difficult. But a 20%-plus drop in oil leading to a rush of defaults among highly leveraged borrowers in the US energy sector is probably the most obvious candidate.