Deutsche Bank Predicts End of Low-Default Era, 20% Sub-BB Debt Matures Soon

Key Takeaway

• Deutsche Bank analysts predict an end to the low-default era, with rising interest rates increasing corporate default rates.
• Over 20% of sub-BB borrowers face debt maturities in the next three years, potentially exacerbating default risks.
• Despite a more optimistic US growth outlook for 2024, Deutsche Bank expects structurally higher default levels in coming years.

Rising Corporate Default Rates

The era of low corporate default rates appears to be ending, driven by the significant increase in interest rates. Analysts at Deutsche Bank AG have highlighted that default rates are expected to rise, even if a major surge might be avoided. "For 40 years, virtually all fixed-rate borrowers across the economy could refi at a lower rate than they’d previously achieved," Deutsche Bank analysts Jim Reid and Steve Caprio noted. This dynamic shifted post-2022, and the full impact is yet to be fully realized. The analogy of a "boiling frog" was used to describe the market's slow recognition of this change.

Central banks' rate hikes to combat inflation have made borrowing more expensive, particularly for riskier companies, leading to an uptick in defaults globally. Despite hopes for a return to low-default conditions, Deutsche Bank remains skeptical about the next few years being as stable. A significant factor is the looming maturity wall, with over 20% of sub-BB borrowers facing debt maturities in the next three years. While defaults haven't surged as previously anticipated, the analysts maintain that structurally higher default levels are likely in the coming years.

Booming Asset-Backed Securities Market

Banks are increasingly turning to the asset-backed securities (ABS) market to offload assets, driven by the latest global capital rules under Basel III endgame. This has led to a surge in ABS issuance, with US sales reaching $170 billion this year, a 38% increase from the same period in 2023. Europe has seen similar growth, with issuance up 35% to €21 billion ($22.9 billion). Bank of America strategists have raised their full-year US sales predictions for ABS to $310 billion, primarily due to auto loan securitizations.

The demand for ABS is robust, with investors seeking securities with strong ratings and high yields. "We see attractive opportunities in asset-backed securities," said Kay Herr, JPMorgan Asset Management’s chief investment officer for US fixed income. The use of significant risk transfers (SRT) by banks is also driving issuance, with SRT deals running at their hottest pace since the 2008 financial crisis. Investors are even exploring more exotic assets, such as art and internet protocol addresses, for securitization.

Impact of Basel III Endgame

The Basel III endgame rules are expected to make certain loans more expensive for banks to hold, prompting them to bundle these loans into ABS. This regulatory shift is leading to increased ABS issuance as banks seek capital relief. JPMorgan Chase & Co.’s CEO Jamie Dimon has criticized the new rules, noting that hedge funds and other non-bank firms are poised to benefit. Federal Reserve Chair Jerome Powell has indicated that the central bank is planning "broad and material changes" to the implementation of these rules, potentially leading to a complete overhaul.

Despite these regulatory challenges, banks are actively preparing for tougher capital requirements. Recent deals include auto bonds from Santander and Toyota, indicating a continued strong pipeline of ABS issuance. However, strategists caution that issuers might be accelerating sales to avoid potential volatility from the upcoming US presidential election or a Federal Reserve policy pivot, which could slow down issuance in the second half of the year.

Street Views

• Jim Reid and Steve Caprio, Deutsche Bank (Bearish on corporate debt market):

  "For 40 years, virtually all fixed-rate borrowers across the economy could refi at a lower rate than they’d previously achieved. This changed after 2022, but the full impact could still be slow to be felt. So there is perhaps a ‘boiling frog’ analogy here where the market doesn’t notice it, until it does."
  "While we changed our view on [a US recession] at the start of 2024 due to a more optimistic US growth outlook, does the argument of a structurally higher level for defaults still hold over the next few years, after 20 years of it being exceptionally low? We think it does."