OREANDA-NEWS. The US high yield bond market has doubled in size since the end of 2008, currently totaling $1.5 trillion. Fitch Ratings believes this could create challenges relating to much higher volumes of defaulted debt during the next peak of the default cycle should default rates approach levels experienced at prior cycle peaks.

A spike in default volumes could result in restrained asset sale activity by distressed companies, lower market valuation multiples and court-approved valuations, low prices on asset sales by distressed issuers and below-average bond recovery rates. In addition, leveraged lending guidance is likely to reduce bank lender interest in providing DIP loans to bankrupt companies and to distressed companies with leverage higher than thresholds for an adverse regulatory risk rating.

Greater mobilization and fundraising of distressed debt investment capital would ease these pressures. Growth of distressed debt capital pools has lagged growth of high yield debt markets in absolute dollar amounts despite robust distressed debt funding. This would create a supply/demand imbalance of distressed debt should default rates approach prior peaks.

Fitch is forecasting a 6% 2016 US high yield bond default rate, which would translate into $90 billion of default volume. This would follow a 2015 default rate of 3.4% and $48 billion of volume. The two-year cumulative rate and volume would be 9.4% and $138 billion, respectively.

The current two-year 9.4% forecast default rate is well below the two-year cumulative 20.5% rate during the most recent default cycle peak reached in the 2008 and 2009 recession. A 20.5% cumulative two-year rate in the current larger-sized high yield market would produce $333 billion of defaults, compared with $171 billion in 2008/2009.

Looking back to an earlier default cycle peak in 2001/2002, a 29.3% cumulative default rate produced $188 billion of volume in the two-year period. This default spike was largely driven by a telecom and internet sector bust. Applying the same peak rate to today's universe translates into $502 billion of defaulted bond volume.

Today, telecom and all other sectors except the beleaguered energy and metals/mining sectors have below average default rates. The trailing 12-month high yield default rate, excluding energy and metals/mining sectors, is relatively low at 1.4%. We expect slow US GDP growth to persist through 2017 and a decline in default rates in 2017 as energy and coal sector filings abate and other sectors' rates remain low. However, a liquidity crisis, unexpected global event (e. g. sharper than anticipated China slowdown), or more severe post-Brexit vote spillover effects than we currently forecast could shift that scenario. Still, Fitch maintains that the near-term risk of a spike in default rates and ensuing flood of defaulted debt is small.

Distressed debt investment funds and private equity (PE) style funds that target distressed asset investments have been actively raising capital over the past seven years in anticipation of rising default rates and increasing opportunities. About $153 billion of funds is ready for the distressed asset class, according to Preqin data. This so-called "dry powder" includes $56 billion in distressed debt funds as of March 2016 and $97 billion of distressed PE fund dry powder as of July 2016, according to Preqin data.

It is unclear how quickly additional capital would be mobilized if a downturn led to much higher default volumes. There would likely be more frequent debt to equity swaps, with pre-petition creditors becoming the majority stock holders post-reorganization and less frequent new money investment in the assets from third parties and asset sales by distressed sellers. This is similar to the current market dynamic for energy and coal companies that have filed for Chapter 11 bankruptcy or are seeking to sell assets while in distress.

For further information, please see our special reports, "Funding Trends for Bankruptcy and Distressed Debt" dated May 23, 2016 and "U. S. High Yield Default Insight" dated June 16, 2016.