What will trigger the next big bust?

Credit markets are currently priced for perfection. But when the cycle turns, the fallout is likely to be severe.

"The current credit cycle is the longest in history," says Achilles Risvas of hedge-fund firm Dromeus Capital, writing in Investment & Pensions Europe. Despite that, credit markets are priced as if nothing can go wrong.

US high-yield bonds offer near-record-low premiums to US Treasuries, lenders have relaxed credit standards and the usual flotilla of high-risk instruments, such as payment-in-kind bonds, have re-emerged.

When the cycle turns and defaults start to rise, the fallout is likely to be severe, not just for low-quality bonds and loans, but also in other markets, such as equities and property. However, "exactly what could awaken the bear is uncertain".

Indeed, calling the turn in the default cycle is extremely difficult, say Oleg Melentyev and Daniel Sorid of Deutsche Bank even though "it's arguably the most important call any credit investor can make".

Valuations, market fundamentals and economic indicators are not reliable; instead, a look back at past credit cycles suggests the key is to spot the "volatility shock".

A large stock of poor-quality debt can exist for a long time as it does today before a clearly identifiable trigger event causes investors to reassess their appetite for risk, "driving lenders away from extending credit to the weakest issuers and leading to an increase in defaults".

Predicting what will bring about this shift in investor psychology is obviously difficult. But a 20%-plus drop in oil leading to a rush of defaults among highly leveraged borrowers in the US energy sector is probably the most obvious candidate.

Recommended

Bonds
Glossary

Bonds

A bond is a type of IOU issued by a government, local authority or company to raise money.
19 May 2020
The charts that matter: inflation, bubbles, and booze
Economy

The charts that matter: inflation, bubbles, and booze

As US stocks head higher into bubble territory, John Stepek looks at the charts that matter most to the global economy.
23 Jan 2021
Inflation is the easiest way out of this – just don’t expect politicians to admit it
Inflation

Inflation is the easiest way out of this – just don’t expect politicians to admit it

The UK government borrowed £34.1bn in December, a record amount for that month. Britain's debt pile now amounts to 100% of GDP. How are we going to pa…
22 Jan 2021
Why bonds may not be the safe haven they once were
Investment strategy

Why bonds may not be the safe haven they once were

“De-risking” by shifting your portfolio into bonds used to make sense. But not so much any more, says Merryn Somerset Webb. So what should you do inst…
21 Jan 2021

Most Popular

Why we won’t see a house-price crash in 2021
House prices

Why we won’t see a house-price crash in 2021

Lockdown sent house prices berserk as cooped up home-workers fled for bigger properties in the country. And while they won’t rise quite as much this y…
18 Jan 2021
The world’s fund managers are getting very bullish – be careful out there
Stockmarkets

The world’s fund managers are getting very bullish – be careful out there

The latest survey of fund managers shows them to be extremely bullish on all the same things. And that, says John Stepek, means the market is in dange…
21 Jan 2021
Prepare for the end of the epic bubble in US stocks
US stockmarkets

Prepare for the end of the epic bubble in US stocks

US stocks are as expensive as they’ve ever been. How can you prepare your portfolio for a bubble bursting?
18 Jan 2021