The credit markets have been showing signs of contagion, as Chinese growth concerns and slumping commodity prices lead to widespread selling.
That has Deutsche Bank wondering if there is likely to be a wave of companies failing to pay interest on their bonds.
It said in a note Friday: “With the recent back-up in both IG [investment grade] and HY [high-yield] spreads to their respective 3.5-year wides, a discussion has emerged about whether the market is sensing the next default cycle around the corner or is simply “overreacting” to some exogenous but ultimately irrelevant events. At 570bp ex-energy spreads, the market is well ahead of what would normally be considered sufficient compensation for defaults that are still tracking sub-2% in this segment of our markets.”
Strategists Oleg Melentyev and Daniel Sorid looked at six leading indicators to judge whether the credit market has over-reacted, and found that two are flashing red – meaning they are “at levels consistent with where previous credit cycles have started.”
The two signals flashing red are volatility shocks, and spreads on the highest rated corporate bonds. As the chart at the bottom of this page shows, the Vix and spreads on AA-rated corporate bonds are moving in a similar fashion to the late 90s and the years leading up to the financial crisis.
