Legendary bankruptcy expert Dr. Edward Altman cautioned that this benign credit cycle — characterized by low default rates, low yields, low spreads, and lots of liquidity — could come to an abrupt end.
“It’s been a terrific market for investors for quite a long time and if anything is concerning it’s that we now are more than eight years into a benign credit cycle,” Altman, a professor at NYU Stern School of Business, told Yahoo Finance. “We’ve never had such a long benign cycle. And just that one little fact is something that we should be concerned about because if it comes to one and it could come to an end very dramatically.”
Altman, the creator of the financial-distress sniffing Altman Z-Score, warned in mid-2007 of a “Great Credit Bubble” and that there was going to be trouble in the market. He predicted that a meltdown would stem from corporate defaults. While the primary culprit of the financial crisis turned out to be mortgage-backed securities, investors who heeded Altman’s warning nevertheless avoided a lot of grief.
So, how does today’s market compare to the market in 2007.
“There are some similarities, yes, although the situation back in the great financial crisis was pre-meditated by the mortgage-backed securities and we don’t have that problem now,” he said.
Troublingly, Altman sees the reckless behavior of 2007 surfacing again.
“Back in 2007 prior to the crisis in ’08 and ’09, the fundamentals of credit risk of the companies issuing bonds and taking out loans were quite low,” he said. “And the similarity that I see now between 2007 and 2016 is very similar fundamentals, quite a bit high risk and it doesn’t seem to bother the market because it’s the only game in town in terms of getting yield greater than what you can get for low-risk securities like governments and high-grade corporates.”
In other words, investors aren’t buying junk bonds just because the risk-reward balance is favorable. They’re buying because the rewards of investing in lower risk bonds just aren’t cutting it anymore.
Companies are no better than they were back in 2007
Altman is perhaps best known for the Z-Score, a formula he created 50 years ago that’s used to predict bankruptcies. Since that time, he noticed that bankruptcies have gotten increasingly bigger.
“[What] I’ve seen over the years is larger and larger companies filing for bankruptcy on a regular basis. On average, in the United States, something like 15 more than $1 billion companies, in terms of liabilities, go bankrupt every year, on average,” Altman said. “This year already it’s 13. Last year, it was almost 40.”
He noted that inflation has something to do with it, but what’s actually happening is companies have been taking advantage of debt and low interest rates like never before, and the corporate debt ratios are way up.
“Speaking about the Z-score, if you compare the average Z-score of companies in 2007 with the average in 2016, which is the last time we looked at it, guess what. The average is actually lower today than it was in 2007, and 2007 was right before the great financial crisis, and of course, in ’08 and ’09 we saw a tremendous increase in corporate bond defaults and loans.”
Low Z-scores are associated with financial distress.
He added: “So the good news is that it’s no worse, but the bad news is, fundamentally, the companies are no better than they were back in 2007 at least by our model.”
At the moment what’s keeping companies from going bankrupt as they did during the financial crisis is the incredible amount of liquidity and low interest rates.
We’ll see how long that lasts.
Julia La Roche is a finance reporter at Yahoo Finance. Follow her on Twitter.