Well, you can swing it you can groove it
You can really start to move it at the hop
Where the jockey is the smoothest
And the music is the coolest at the hop
All the cats and chicks can get their kicks at the hop
—“At the Hop,” by Artie Singer, John Medora and David White; originally released by Danny & the Juniors
If you substitute “top” for “hop,” this song does a pretty good job of describing today’s credit markets. That means if you are taking credit risk, life is good—right?
Not so fast.
It is true that global economic news has been positive and defaults have remained muted throughout the recovery. The October 2017 Senior Loan Officer Opinion Survey on Bank Lending Practices indicates that banks continue to ease lending standards for commercial and industrial loans, as well as all categories of residential real estate, and they are tightening standards for credit card and auto loans to subprime borrowers.
It is also true that bond ETF inflows have been at record levels. Volatility levels, while up from earlier in the year, remain very low historically, reflecting a neutral level of investor anxiety.
On the other hand, the Kamakura expected 10-year cumulative default probability for all rated firms worldwide is 14.59%, compared to 13.33% in September, 2008. (The expected cumulative default probability model is a forward-looking measure with excellent predictive value.) Spreads, however, seem to expect that credit conditions will remain benign, as you can see below:
Our research shows that credit is simply not easy to parse. The relationship between credit spreads and matched maturity default probabilities is not a consistent one. We also know that credit spreads are not a reliable indicator of corporate distress. Our founder and CEO, Dr. Donald van Deventer, explored one of the most persistently used formulas regarding credit spreads and default probabilities in his January blog post, Credit Spreads and Default Probabilities: A Simple Big Data Model Validation Example.
It is always easy to identify market peaks in hindsight, but not so easy in the midst of ongoing events. It would be precarious to call a top today. Many asset classes are trading above historical norms, interest rates are at historic lows, volatility is low, and no one—including central banks—really knows how the deleveraging of central bank balance sheets will affect the economy. Price insensitivity is one of the hallmarks of buyers on the way up—or sellers on the way down.
Ratings can’t help you, either. They don’t identify where we are in a cycle, nor do they provide guidance on where a credit shocks might come from.
Although short-term credit conditions remain good, it bears repeating that the Kamakura expected 10-year cumulative default probability is higher than it was prior to the Great Recession.
So what’s a credit manager to do? The best answer we can offer is that you should stress macro factors for credit spreads and default probabilities. When it comes to credit, there are no easy answers—only good analytical tools and constant vigilance.