Market Focus. Credit cycle: rising default rate. Where do we stand in the default rate cycle? Credit fundamentals are deteriorating

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1 At the beginning of 215, we began forecasting the end of the credit cycle. Since then, corporate fundamentals, rating trends, and default rate data have all deteriorated. Moody s speculative default rate for example rose from 1.7% in Q1 214 to 4.7% in July 216 and the institution expect the rate to reach 5.1% by the end of the year. In such an environment, we wonder where we now stand in the default rate cycle, and how far credit spreads can continue to tighten? Moody's global speculative-grade default rate came in at 4.7% in July, above its long-term average of 4.2%. Among the 6 defaults observed year-to-date, 35 were in the energy sector, however 7 were in financials, 7 in industrials, and 8 were in consumer sectors (5 in cyclical and 3 in non-cyclical). While some investors consider that this rise is not cause for concern because of the concentration in one sector, other data shows that corporate health is continuing to deteriorate. Credit fundamentals are deteriorating While Q2 earnings reports were generally better than expected, sales and earnings growth trends were down vs Q1 in both Europe and the United States. While the poor figures for oil & gas and basic materials were not surprising, investors should note the particularly weak results in the US utilities and EU telecom sectors. Upgrade and downgrades (par issuer) This fundamental deterioration is largely reflected by the rating agencies bias. We have observed nearly two downgrades for one upgrade, and there have been 41 fallen angels vs. only 9 rising stars year-to-date. We source: J.P. Morgan Upgrades Downgrades Ratio (Up/Down) remind our readers that between and 214, we observed more positive changes than negative ones. Rising Stars vs. Fallen Angel (par issuer) Rising Stars Fallen Angels Ratio (Up/Down) 1998 source: J.P. Morgan Looking at the breakdown of the outlooks and watch lists from the rating agencies (annexe n 1), the negative trend is still on-going. Only one sector has a positive bias (with more positive outlooks and watch lists than negative ones and with seven rising stars vs. one falling angel YTD): the auto sector. Where do we stand in the default rate cycle? The deterioration in fundamentals, and higher default rates, raise some questions. When will default rates peak, and what are the drivers to watch out for? Clearly the default rate tends to increase in tough economic times and decrease in times of economic prosperity. However, recessions - two consecutive quarters with negative GDP growth - are not always necessary to observe a rising default rate. It is more the GDP trend, rather than absolute growth rate, which is relevant. In 198, we have observed a recession without 27 vs. USD GDP Real US Recession US GDP (inverted) / 5 Caroline Weber, CFA

2 a default rate peak and in 21, we had a default peak while the economy was not in recession. A slowing GDP results in a higher default rate. Looking at other leading indicators of the default rate, we have identified two potential data points: the unemployment rate and the steepness of the government curve. vs. US Unemployment Rate US Unemployment Generally, there is a slight lag between the unemployment rate and a slowdown in activity. Consequently, the unemployment rate is not really of much use in determining the beginning of rising trend. However, the default peak is never reached before the unemployment rate starts rising. The peak in the default rate occurs often one or two years after the unemployment rate bottoms. If markets are efficient, the government yield curve vs. USD Yield Curve Steepness flattens when anticipating an economic slowdown. Consequently, the slope of the government curve is a Curve Steepening (inverted) leading indicator of growth expectations whilst growth is a leading indicator of the default rate. A flat government yield curve anticipates a default peak by roughly 2 or 3 years. Currently, the USD yield curve is flattening, but we are still some way away from a flat curve. However, given the current central bank driven market distortions (massive QE programs and negative yields), we are not sure if this factor will prove to be a reliable indicator in this default cycle. Consequently, we will mainly focus on the two other indicators: GDP growth and the unemployment rate. While the US economy is still relatively strong, signs of weakness are appearing. As a result, downside risks are rising, and default rates may increase next year. From a financial perspective, credit spreads are highly correlated to the evolution of the default rate as the credit spread should compensate for a higher probability of default. Consequently, the widening trend, which began in the summer of 214, may continue in coming years, despite central bank manipulations. Central banks QE programs may contain the range of the spread widening, but we do not think that it will reverse the trend. vs. HY spreads '2 1' As discussed in our market focus in July, the US labour market is not yet reversing. However, in anticipation of a slowdown in US activity next year, we believe that the US unemployment rate will bottom in 217. Based upon these indicators, we expect the default rate to rise further in coming years, and to peak around HY Spreads / 5 Caroline Weber, CFA

3 Search for yield: surging portfolio risk? While the speculative default rate is a good indicator of the credit cycle, this measure does not necessarily reflect the actual risk faced by most bondholders because the majority of portfolios are focussed upon Investment grade issues. Consequently, it is better to use the average default rate by rating. 1 year Average Default Rate ( ) Investment Grade (.1%) High Yield (4.21%) 1.58 Downgrades from rating agencies (refer to annexe 2 for more details) and voluntary decisions to reduce credit quality, or to lengthen duration, are all factors which have significantly increased the default risk of portfolios. Interestingly, Moody s statistics show us that reducing credit quality adds more risk than lengthening duration. Inv. Grade Cumulative Default Rates ( ) Aaa Aa A Baa Aaa Aa A Baa Ba B Caa-C However, with the exception of money market funds, most investors portfolios have durations of longer than one year they are generally in the range of 3 to 7 years. Consequently, such data underestimates the risk, as it measures the percentage of issuers for a given rating that failed to make scheduled interest or principal payments in the prior 12 months. This means that cumulative default rates are more relevant to identify the risk faced by a bondholder s portfolio. 5 year Cumulative Default Rate ( ) Investment Grade (.98%) High Yield (19.68%) Aaa Aa A Baa Ba B Caa-C For example: A with a life to maturity of 4 years is.61% BBB with a life to maturity of 4 years is 1.27%. A with a life to maturity of 6 years (2 years longer) is 1.16%. High Yield Cumulative Default Rates ( ) B Ba Caa-C In the current low yield environment, the additional risk faced by the bondholders has surged! 3 / 5 Caroline Weber, CFA

4 Annex 1: Migration Statistics - Rating bias Standard and Poor's Moody's Rtg Negative Positive Ratio Rtg Negative Positive Ratio Financial (Cyclical) Banks A A Diversified BBB+ 3 BBB+ 6 Financial BBB+ 9 1 BBB Insurance A 4 2 A- 4 1 Real Estate BBB- 5 5 BBB 11 4 Non-Financial (Cyclical) Auto BBB+ 3 7 BBB Basic Materials BBB- 9 BB+ 3 3 Chemical BBB 11 1 BBB Communications BBB 3 2 BBB 5 Energy BBB BBB Industrial BBB 12 4 BBB 29 4 Leisure BB 1 3 BB+ 4 Services BBB 3 1 BBB 3 2 Technology BBB+ 6 1 BBB+ 9 2 Non-Financial (Defensive) Food BBB 4 3 BBB 12 3 Healthcare A- 8 BBB Retail BBB 9 4 BBB 12 1 Telecom BBB 6 3 BBB 16 2 Tobacco A- 1 BBB+ 1 Transport BBB 12 3 BBB+ 1 1 Utilities BBB A Public (Defensive) Agency A+ 9 2 AA- 8 1 Government A+ 2 1 A 1 Sovereign BBB BBB 16 4 Sub-Sovereign A+ 5 1 A 1 Supranational AA+ 2 AA+ Negative = negative bias = negative outlook or negative watch list Positive = positive bias = positive outlook or positive watch list Source: Keox 4 / 5 Caroline Weber, CFA

5 Annex 2: Migration Statistics - Rating migration Average One-Year Letter Rating Migration Rates, (WR not included) End-of Period Rating Aaa Aa A Baa Ba B Caa Ca_C D Downgrades Aaa Aa A Baa Ba B Caa Ca-C Upgrades Average Five-Year Letter Rating Migration Rates, (WR not included) End-of Period Rating Aaa Aa A Baa Ba B Caa Ca_C D Downgrades Aaa Aa A Baa Ba B Caa Ca-C Upgrades Source: Moody s Annex 3: Recovery Rate - Distinguish issuer and issue rating Recovery Rates based on 3-days post-default market prices based on ultimate recoveries Sr. Unsecured Bank Loan 47.1 Bank Loans 8.4 1st Lien Bond nd Lien Bond 49.7 Sr. Secured Bonds 63.3 Sr. Unsecured Bond 37.6 Sr. Unsecured Bonds 48.8 Sr. Subordinated Bond 31.1 Sr. Subordinated Bonds 28.2 Subordinated Bond 31.9 Jr. Subordinated Bond 24.2 Source: Moody s 5 / 5 Caroline Weber, CFA