Too Safe to Fail: Implied Default Rate for European Junk Bond is Negative 1.1%

Apparently, European junk bonds are too safe to fail. Fundstrat Global Advisors’ Thomas Lee says the market-implied default rate for a European junk bond sits at a negative 1.1%.

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.

Mike "Mish" Shedlock

Judging by the ECB's own projections, they will be engaged in QE until at least 2020. So things will carry on in this direction for a long, long time and get even more amazing in the meantime.

Isn't this rational, though? Think about it- so many big institutions have been forced into buying this debt over the last 5 years that the central bank of Europe will be forced to cover any defaults.

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