Defaults are beginning to loom over the markets

Over the next five years, they could affect a fifth of subprime debt

Believe it or not, investors sometimes think about things that are not directly related to interest rate policy in the United States, writes British journalist Katie Martin for the Financial Times.

Of course, the debate over what the Federal Reserve should do next is important. This is by far the biggest question right now. It once again dominated an otherwise sleepy summer market environment last week, thanks to data showing a modest slowdown in inflation.

Annual inflation slowed to 8.5% in July, data showed on Wednesday, from 9.1% in the previous month, fueling expectations that the Fed could be persuaded to ease rate hikes. This so-called focus has been on and off more times in the past month than I care to remember. It has a shelf life as the main policy agenda of a Tory leadership candidate. But now, at least to some extent, it’s back, supporting the stock.

Surely this could be the start of something big. Maybe inflation will really come down from here on out. Maybe it was transient after all, if you can stretch that definition far enough. But if you think the Fed is going to take its foot off the brake at 8.5 percent inflation given its 2 percent target, then you’re very naive.

“Even if we had zero monthly inflation every month (which would be incredibly expansionary in monetary terms) by the end of the year, we would still have inflation above 6% in December,” Mirabaud analysts noted. “Momentum may be slowing, but … 8.5 percent is still too high.”

Mary Daly, president of the Federal Reserve’s San Francisco branch, highlighted this in an interview with the FT. “We don’t want to declare victory over inflation,” she said. “We’re not close to being done yet.” Will this end this debate? No chance.

One of the problems is that this noisy exchange, important as it is, drowns out everything else. Meanwhile, many bond investors have a different matter on their minds: defaults. They were something of a rarity while central banks were flooding the system with money, but failures by governments and companies to pay back what they owe are expected to become much more common.

With sovereign debt, this can become very difficult, especially for those countries that have borrowed in dollars, which are now much more expensive to pay back. Leland Goss, general counsel at the International Capital Markets Association, pointed out in a recent report that even in the decade before Covid, borrowing in emerging markets had grown from $3.3 trillion, or about a quarter of GDP, to $5.6 trillion. almost a third.

The strain is beginning to show in Sri Lanka, which has already admitted it cannot return money to investors, but also in bonds issued by Kenya, Egypt and elsewhere. The prospect of a “possible systemic sovereign debt crisis” is real, Goss says.

The nightmare scenario here is for many defaults to occur at once. “Lenders with exposures to many sovereign borrowers could face big problems,” Goss points out. “Creditors themselves may experience financial distress and potential systemic effects, particularly if they are financial institutions.”

This is indeed a potentially pressing issue for fund managers with concentrated exposures to emerging markets, and if Goss is right, it’s worth the rest of us keeping a close eye on the situation. There is no “magic wand” to solve this, he notes, but “a pre-emptive, coordinated multilateral debt restructuring” can at least bring some order to the process.

Investors in corporate debt are also braced for a tougher environment. “I’m not predicting a collapse at all,” commented Pierre Verlet, head of credit at Carmignac, a European asset manager. “I don’t expect an uncontrollable wave of defaults, but we are re-entering a world where capital has a price.”

The ICE Bank of America Euro High Yield Bond Index shows this very clearly. At the start of this year, the yield – a measure of borrowing costs – hovered around just under 3 percent. Remember, this is for risky borrowers, not safe issuers. That yield has now reached 6%, after surpassing 7% in July, when concerns about interest rate hikes by central banks peaked.

Ratings agency Fitch believes that as economic risks intensify and benchmark interest rates rise, defaults on subprime debt could double in the US this year from last year, reaching 1%, and double in Europe to 1.5%.

Wehrle thinks that overall the level could be much higher. “Over the next five years, I think we’ll see defaults of 4 percent a year on subprime debt, or a total of one in five will default.” That’s a lot.” Such levels would take us back to what we saw in 2020 — which was a bad year.

That doesn’t worry Wehrle – his previous work with troubled debt markets has prepared him for such experiences. “My expectations are very, very low,” he says.

The raging debate over the Fed’s primary focus is draining much of the markets’ intellectual energy, and for good reason. But distracting yourself from other problems is at your expense.


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