The market’s expectation for an average European high-yield bond to default on its payments stood at negative 1.1% on Oct. 26, versus a long-term average of a positive 5.8%, according to an analysis released Friday by Thomas Lee, the head of research at Fundstrat Global Advisors, who attempted to demonstrate the pernicious consequences of quantitative easing.
“We see this creating a ‘moral hazard’ which allows bad businesses to borrow money and misallocate. After all, wouldn’t anyone want to borrow money at cost of debt less than the U.S. government?” said Lee.
But Martin Fridson, chief investment officer of Lehman Livian Fridson Advisors and a veteran high-yield bond analyst, has criticized the principal way money managers and market strategists like Lee calculate the market’s expectations for the default rate, which uses the option-adjusted spread as a jumping-off point. By his own calculations, the default rate for an average European junk bond should be 0.2%, still a very low level.
Fridson, nonetheless, conceded the ECB was one “root cause” for the seemingly stretched valuations seen in the market for European corporate paper.
Debate Over Risk
Depending on your point of view, the implied default rate on European junk bonds is -1.1% or as high a 0.2%.
One hell of an unwind is coming. I wish I could tell you when.