Here's who is going to get crushed by the coming 'tsunami' in the debt market

Reuters

It's going to get ugly in the bond market soon, and there are a few companies that have more reason to worry than others.

Matthew Mish, a credit strategist at UBS, has been worried about the bond market for some time now.

The combination of lower profits, higher borrowing costs, and tighter lending standards have him calling for a "tsunami" of defaults to hit the high yield bond market soon.

This wave, however, will not treat each sector equally, according to Mish. The energy sector is already getting demolished by high yield defaults, and it will not be the last to feel the pain.

"Bottom line, while no mosaic is ever clear and complete, these trends infer a series of shallower, more broad-based default waves which will likely be concentrated in (non-bank) financials, industrials, tech, retail and healthcare," wrote Mish in a note to clients on Thursday.

"Investors should be more cautious and selective when allocating to these industries given defaults tend to be clustered and fat tailed."

Mish argued that the amount of debt issued is not just important to look at going back to the financial crisis, but all the way back to 2003 after the tech bubble burst.

"Historically, debt growth has been one potential harbinger of future stresses (e.g., telecommunications in the late 90s) – a topic we have discussed in prior research," said Mish.

"However, one of the facets of the last credit cycle is that while peak default rates hit all-time highs, cumulative default rates were remarkably shallow in the context of the economic environment. Why? In our view, central banks cut the cycle short, eased policy aggressively and liquefied the credit system."

Thus, credit growth back to 2003 is an important metric and the five sectors that Mish mentioned experienced a boom in debt issuance. For example, the finance industry has increased it's outstanding high yield debt by 720% since 2003 and tech has seen a 420% jump in that timeframe.

Reuters

This debt is just the "kindling for the fire" according to Mish. As we've noted before, the concern isn't total debt issued, it is the ability of those indebted companies to pay back what they owe. With profits on the slide for these sectors, it will be harder for them to keep up with their obligations.

Mish points to the current trends in speculative grade debt, the most risky bonds, and argues that they are signaling a large problem for borrowers is on the way.

Almost every sector Mish identified as a problem area has seen a serious uptick in speculative grade defaults in the past few months, which signals that the default wave is going to come crashing down on the five sectors in the near future.

For example, in financials the speculative grade default rate was 7.2% at the end of April, according to data from Mish. Just six months ago the rate was sitting at 1%. In industrials, it climbed to 2.6% from 0.9% six months ago.

The combination of high levels of issuance and deteriorating profitability will end up in pain for retail, financials, industrials, tech, and healthcare companies.

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