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The case for structurally lower credit losses

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      By Jeffrey D. Mueller, Portfolio Manager, High Yield Team and Justin H. Bourgette, CFA, Portfolio Manager, Global Income Team

      Boston and London - One sure fire way to guarantee that you permanently impair capital in credit markets is to invest in an issuer that fails to meet its repayment obligations (ie one that defaults) and for the residual assets of the issuer to be worth not very much after it defaults (ie for recovery rates to be low).

      Credit spreads are tight but so are our expectations for credit losses

      Credit spreads are tighter today than their historic averages across a number of areas of leveraged credit markets, including global high-yield corporate bonds and floating-rate bank loans, which are the primary focus for the Eaton Vance Multi-Asset Credit (MAC) Team. If you believe that the primary risk that you are compensated for in these markets is default risk, the key question for credit markets investors is whether loss rates will increase to a level that is likely to erode some, or all, of the credit spreads available in the market. In the view of the MAC team, that is not the most likely case.

      Loss rates reflect the default rate multiplied by the recovery rate for a given issuer that gets into trouble. Looking forward, our expectation of lower-than-historic loss rates is primarily based on lower-than-historic average default rates, partially offset by lower recovery rates.

      While we will likely have pockets of volatility over the short term, over the longer term we expect structurally lower losses both for global high-yield corporate bonds and floating-rate loans. Despite tighter-than-average credit spreads, we still think positive excess returns are possible across numerous parts of leveraged credit markets.

      In the chart below, each bar represents rolling five-year average loss rates. Notice that since 1987, these have averaged 2.5%, which is higher than the 1.8% we have experienced for the five years ending in 2018. Our base case is that loss rates will increase modestly form these historically low levels to an average of 2.1% over the next five years.

      Our bear case (higher defaults and lower recovery rates) is an increase of 4.4% and the bull case (lower default rates and higher recovery rates) is a decrease to 1.1%.

      We expect loss rates to stay below long-term average.

      MACblogimage

      Source: Moody's Global Annual Default Study (2018), and Eaton Vance Multi-Asset Credit Investment Team (May 2019). Projections are for Index performance (the ICE BofAML Global High Yield Index and the S&P/LSTA Leveraged Loan Index).

      The structurally lower loss rates we foresee are primarily due to lower default rate expectations, caused by:

      1. The U.S. Federal Reserve (Fed) and the European Central Bank (ECB) appear terrified of economic downturns, recessions and a worsened corporate default environment, and have moved to prevent such scenarios. For example, the Fed has hit the "pause" button twice - first in January, then in March. The ECB is also looking to add more stimulus through targeted lending operations.
      2. The absence of any meaningful inflation expectations means weaker-than-historic nominal growth is enough to keep credit market conditions reasonably benign.

      With credit spreads tighter than their historic averages, the ability to avoid losses in the global high-yield and floating-rate sectors will be key to generating positive excess returns from these markets. The MAC team has always believed that focusing on fundamentals remains the most important aspect of investing in leveraged credit markets, and that is likely to be especially true over the next several years.

      Bottom line: We think loss rates for leveraged credit over the next five years are likely to stay below their long-term average. We believe that careful credit selection, founded on intensive fundamental research will be vital for investment success in this environment.

      ICE® BofAML® indices are not for redistribution or other uses; provided "as is", without warranties, and with no liability. Eaton Vance has prepared this report and ICE Data Indices, LLC does not endorse it, or guarantee, review, or endorse Eaton Vance's products. BofAML® is a licensed registered trademark of Bank of America Corporation in the United States and other countries.

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