Why investors can use loan default rates to predict a recovery

Part 2
Why investors can use loan default rates to predict a recovery (Part 2 of 4)

Why do loan defaults closely relate to economic recovery?

Loan defaults and recovery

The chart below reveals how outstanding loans in default have fluctuated with economic conditions in the U.S. Loan defaults peaked in 2009, which was the time of the credit crises in the U.S., when the recession had hit the economy hard. Market fluctuations caused by the crises also affected the ETF industry, with popular ETFs like the iShares S&P 100 ETF (OEF), which is a large cap equity fund with holdings in blue chip companies like Apple Inc. (AAPL) and Exxon Mobil Corporation (XOM), the iShares Core Total US Bond Market ETF (AGG), and the Vanguard REIT Index ETF (VNQ) facing a price decline close to 14.50%, 55%%, and 70%, respectively, during the period of recession.

Gradually, as the economy has recovered post-2009 from its recessionary phase, loans in default have moderated to lower levels.

Par Amount of Outstanding Loans in Payment DefaultEnlarge Graph

The default rate is the percentage of debt holders who default of the total number of debt holders. For example, if there were a total of 100 debt holders and 15 of them ended up defaulting on their debt, then the default rate would be 15%.

Default rates tend to increase in tough economic times and decrease in times of economic prosperity. During the crisis of 2008, default rates rocketed to record levels. This essentially means the probability of these issuers defaulting on the interest rate and principal payment was much higher than usual.

So, when the default rate is increasing, you can deduce that people don’t have enough money to service their obligations, showing signs of an economy under recession. On the other hand, when an economy recovers from a recession, economic activity increases and unemployment decreases. As a result, people have more money to service their loan obligations.

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