Default expectations have started to fall from the highs reached during the first half of the year. The distress ratio, which looks at the share of bonds with a credit spread of more than 1,000bps, is moving closer to the levels seen before the pandemic and oil-price war erupted (see figure 1).
Figure 1. The distress ratio comes down
Source: ICE Bond Indices, as at August 2020.
This can be explained in part by stronger earnings. With two earnings seasons since the pandemic emerged – and the first that contains a full three months under the new normal – managers have been better able to plan for the future, raise liquidity and provide guidance. This has made it easier to model future outcomes after the hit to earnings earlier in the year which led to record levels of volatility and the worst first half of the year in the history of credit markets.
An influx of central-bank liquidity and government initiatives have since helped to dispel fears that funding markets would break down for companies, which has dampened volatility and driven inflows into credit markets.
The composition of the credit universe has also changed, as a record amount of fallen angels – or issuers downgraded from investment-grade status – have descended, while weaker names have defaulted and exited the index. Both these factors have helped to reduce the proportion of bonds trading at unsustainable levels.
Although distress ratios have fallen, the focus should now turn from issuers that were struggling before the coronavirus crisis emerged to those that might fail to adjust their debt levels for post-coronavirus levels of cash generation. As a result, the default rate is likely to remain relatively high in the months ahead.