Opinion – Credit market: what is the default rate?

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Our approach leads to a moderately pessimistic view: a default rate that rises above its long-term average next year but remains well below acute crisis levels.

The last move brought the spreads to a more reasonable level. With the Sword of Damocles of a potentially much more negative economic scenario, much of the tightening is likely to be left behind.

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Faults inevitably increase

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In terms of financial leverage and debt, the situation is not alarming at the moment. The chart below shows the ratio between debt level and company profits.

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Regarding institutional capital, we get the same signal at very reasonable rates.


It should also be noted that net debt is clearly lower than gross debt, indicating that companies are comfortable at their disposal and have an unusually high liquidity buffer.

Despite this finding, the default rate should inevitably increase for two reasons:

  • On the one hand, as we said in the introduction, a recession seems inevitable and will therefore worsen these rates. The most fragile societies, as always, can be disproportionately affected.
  • On the other hand, the increase in interest rates creates more difficult financing conditions for companies. The chart below shows IG rates hovering between 0% and 0.5% for most of 2021. Currently at 4.33%.


However, it should be noted that there is no debt wall. Businesses are not harmed. On the one hand, as we mentioned above, because they have a lot of liquidity. On the other hand, the basic distribution is spread over the next three to four years, as the refinancing maturities are quite long.

What does the ECB say?

The ECB just released a very interesting statement. “Working Papers Series” titled “The log of a death forest: does higher volatility predict corporate default?” » [1].

In summary, the idea is to see if stock volatility is a good indicator of future defaults. Conclusion :
“We are testing whether a simple measure of corporate bankruptcy based on return on equity volatility – and called Distance to Default (DaD) – produces better corporate default estimates than the widely used Expected Frequency of Default (EDF) measure calculated by Moody’s. »

The exchange’s preferred measure of volatility is V2X, which is the equivalent of VIX for the Euro Stoxx. But to be a little more nuanced, the ECB document also talks about specific risks at each security level. The idea is that certain volatility in a record is a sign of nervousness. It’s also a sign of “controversy” among investors (even if the ECB doesn’t formulate it that way). And therefore, ultimately, the risk of trajectory change. Note: This risk is potentially upside: not all news is bad news. Therefore, an increase in intrinsic risk is a relevant signal for determining the risk of a future default.

The interest of the article is to show that this intuition is valid in the sense that the approach is highly effective in predicting future movements in deposit rates.

Precision is important in the model. The idea that volatility is an indicator of “distance to default” (DaD) is not new. In particular, the famous Merton model comes to mind, which compares debt to the sale of a put option on the company’s assets, whereas capital is a put option. The probability of default then, of course, depends on the risk and hence the volatility, but also on the “strike” of the leveraged option in this case. The intuition is simple: a higher debt-to-equity ratio corresponds to a higher “strike” and therefore increases the likelihood of companies defaulting. In this respect, the discussion in the previous section is important: DaD is higher for a given volatility if debt, and especially corporate net debt, falls as we have shown. This effect has of course been taken into account in the ECB study and our approach (see below). Therefore, the current situation also implies that companies as a whole have increased their resilience to external shocks.

The following charts from the article show the dynamic response of euro area non-financial speculative grade corporate default rates to four shocks determined from a monthly VAR model: bond spread shock, VIX shock, FDE and DaD. Shocks are defined by the Choleski factorization of the VAR covariance matrix. The X-axis shows the months after the shock.


our view

We created a default model for the European HY based on a number of variables:

  • Key variables: GDP growth and unemployment
  • Market variables: the level of rates and the slope of the curve
  • Risk variables: In the spirit of the ECB document, we take V2X as representative.

The result is shown in the graph below. The default rate was extremely low last year, almost zero. For the reasons outlined above, due to rising rates and the recession, our model expects annual defaults to rise above 4% by the end of next year. This should be compared to an average default rate of about 3½%, so that’s bad news, the trend is unfavourable. However, this figure should also be compared with the more than 12% achieved in 2002 or 2009.

Therefore, it is a deterioration with a default rate above the average but well below the severe crisis periods.

This view is consistent with the ECB report and the level of risk implied by the market.

The chart below shows the relationship between all values ​​of Euro Stoxx. If this correlation is strong, it means that the stocks are moving in a synchronous manner and on the other hand, there are few specific movements and thus inherent risks. We put this forecast against market volatility as measured once again by V2X.

The two curves are closely related:

  • When V2X is high, there is a severe shock affecting all values ​​and therefore they tend to correlate.
  • When V2X is low, it is also because the values ​​differ in their performance and therefore the average variation is low if there is no common trend.


Interestingly, the two curves tend to diverge recently. V2X is close to its long-term average of 20. It’s a relatively quiet market. In this case, the correlation between stocks should also be close to the long-term average, but much higher. This tends to suggest that different values ​​are acting at the same time and thus the intrinsic risk is much lower than normal.

Solution

In summary, our approach, and one that follows the work of the European Central Bank, leads to a moderately pessimistic view of credit, with the default rate starting at an extremely low level and rising above its long-term average next year. well below acute crisis levels.

On the other hand, the markets predict a much more negative scenario. From the credit spreads, we can calculate an implied probability for the cumulative default rate over the next five years. The chart below summarizes the calculations. The implied default rate has dropped significantly with the recent good performance of the markets: in HY we went up to 35% from this year’s highest expectation of 44% (in IG we were at a maximum of 18%, now we are at 14%) .

The market therefore went through a much higher risk premium than our approach and models justified. The last move brought the spreads to a more reasonable level. With the Sword of Damocles of a potentially much more negative economic scenario, much of the tightening is likely to be left behind.

Source From: Google News

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