How to Take Advantage of Rising Defaults

Editor's note: Default rates are on the rise. That's causing unease among investors and companies alike. And according to Rob Spivey – director of research at our corporate affiliate Altimetry – it's time to prepare for a rocky road ahead. In this article, adapted from a November issue of the free Altimetry Daily Authority e-letter, Rob explains what's happening with default rates... and shares where to put your money right now.

The cracks are starting to show in the economy...

To see what we're talking about, look no further than bankruptcy lawyers. As default rates rise, law firms with big restructuring practices are benefiting.

Take New York City-based White & Case. The firm's restructuring unit is on track for record revenue in 2023. And Chicago-based Kirkland & Ellis recently picked up the massive WeWork restructuring case.

According to credit-ratings agency Moody's, the global default rate for high-yield debt rose to 4.5% in September... surpassing the 4.1% average. In the U.S., the default rate is sitting at 4.9%.

Last year, the firm predicted the U.S. default rate would rise to at least 5.4% by now. We're not there quite yet... But that's a pretty bleak forecast nonetheless.

Investors haven't fully caught on to this story yet. So today, I'll examine a hidden investment opportunity as the market buries its head in the sand...

When the economy starts to falter, "riskier" companies are the first to fall.

Typically, these businesses' cash flows are less predictable... they have fewer assets to offer up as collateral... or they're just smaller with less borrowing history. They tend to struggle when interest rates are high.

Based on the latest data for 2023, 118 U.S. corporations defaulted. That's almost double 2022's total. And when companies are going bankrupt, the market panics.

Stocks sell off... and so do bonds.

In particular, folks sell out of high-yield bonds – debt issued by those riskier companies – in droves. They lose faith in these companies' ability to stay solvent as their peers default.

Investors are right to be worried... to an extent. A recession is on the way. But as so often happens, they're also overreacting. Moody's projects that in the coming downturn, 14% of companies will default at most.

That still leaves 86% of companies alive and well.

Panic-selling is hard on the stock market... But it's great for bond investors.

You see, bonds are a legal contract. As long as the company doesn't go under, you lock in your return when you buy in. It's an opportunity to get stock-like returns with much less risk.

Remember, bond prices and yields are inversely related. Investors demand extra compensation for bonds they deem more likely to default. So when the bond market dashes for the exits and prices drop... your potential yield soars.

We can measure fear in the bond market using the "high-yield spread." That's the difference between the yield on high-yield bonds and the yield on U.S. Treasury bonds maturing around the same time.

As you can see in the following chart, the high-yield spread spiked during the past three downturns – the dot-com bubble, the Great Recession, and early in the pandemic. On average, it rose to at least 7% each time...

Every time defaults rise, so does the high-yield spread. But that hasn't happened yet today. The spread is currently sitting below 4%.

We don't expect investors to remain this calm for long...

As more high-profile companies go bankrupt, the market will be forced to face the facts. And with banks less willing to lend, more defaults will start popping up soon.

Credit investors tend to be more risk-averse than stock investors. In other words, the credit market often acts as an early warning bell. So we'll likely start seeing bonds sell off before the stock market does the same.

If your entire portfolio is in stocks right now, it's time to reconsider your approach. Equities are in for a bumpy ride... But savvy investors will use high yields in the bond market to their advantage.


Rob Spivey

Editor's note: In 2009, Altimetry founder Joel Litman warned investors about 57 different companies that were about to go bankrupt. Within days, 50 of them collapsed. Now, he's stepping forward with another urgent message...

Joel believes a massive wave of bankruptcies is on the horizon... and it could be far worse than what happened in 2009. That's why he says you need a radically different approach this time around – a strategy that can deliver double-digit income... plus huge potential capital gains... without touching a single stock. Click here to learn more.

Further Reading

"If you're only paying attention to bankruptcies, you're missing the bigger picture," Joel writes. Bankruptcy data is important. But other measures can help investors uncover the true extent of corporate America's stress... Learn more here.

"The private-equity industry is full of dead money," Rob writes. Bankruptcies hit the private-equity space hard last year. And that poses a problem for both private and public markets. So if your portfolio is solely invested in equities, it might be time to diversify... Read more here.