What Does the Future Hold for Credit Risk?

07/05/2022 07:44 AM

What Does the Future Hold for Credit Risk?
Kamakura Troubled Company Increases by 0.53% to 7.24%
Credit Quality Declines to the 85th Percentile

NEW YORK, July 5, 2022: Markets experienced their worst performance in 50 years during the first half of 2022, primarily due to inflation.  The Federal Reserve reacted to the realization that inflation was not transitory after all.  Supply constraints remained as demand continued to exceed supply levels.  Central banks were left with one policy tool with which to fight inflation:  trying to slow demand.  The question is, can they succeed without endangering a soft landing?

The Kamakura expected cumulative default models have been flashing cautionary signals for quite a while, and short-term default risk rose this month. The Kamakura Troubled Company Index® shows that short-term default risk jumped over the month as credit quality declined and credit conditions dropped three points to the 85th percentile of the period from 1990 to the present.  The 100th percentile indicates the best credit conditions during that period. The Kamakura Troubled Company Index closed in June at 7.24%, compared to 6.71% the month before. The index measures the percentage of 40,500 public firms worldwide with an annualized one-month default probability over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the close of June, the percentage of companies with a default probability between 1% and 5% was 6.01%, an increase of 0.37% from the previous month. The percentage with a default probability between 5% and 10% was 0.85%, an increase of 0.14%. Those with a default probability between 10% and 20% amounted to 0.30% of the total, no change from the prior month; and those with a default probability of over 20% amounted to 0.08%, an increase of 0.02% over the prior month.  Volatility decreased, with default probabilities ranging from 6.11% on June 20 to 8.45% on June 13.

Figure 1: Troubled Company Index — June 30, 2022

Among the 20 riskiest-rated firms listed in June, 10 were in the United States, two each in China (including Hong Kong), Luxemburg and Sweden, and one each in India, Ireland, Switzerland and the UK. The riskiest-rated firm was Exela Technologies (XELA:NASDAQ), with a one-month KDP of 28.99%, up 2.20% from the previous month.  There was one default in the Kamakura coverage universe in June, a firm in the United States.

Table 1: Riskiest-Rated Companies Based on 1-Month KDP – June 30, 2022

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate up 0.28% at 2.38% and the 10-year rate down 1.10% at 15.7%.

Figure 2: Expected Cumulative Default Rate — June 30, 2022

Commentary
By Martin Zorn, Managing Director – Kamakura Corporation a SAS company

Despite having some of the world’s best economists, modelers and analysts on staff, the Federal Reserve did not detect that inflationary pressures were becoming embedded in the economy until it was forced to become reactive. The Fed’s models appear to have predicted that supply constraints would ease or demand decline—until the forecasts abruptly changed.

There are two important lessons here. One is that if the models used by the Federal Reserve were wrong, your models can be wrong as well.  The second lesson is the importance of stress testing and having a robust plan to react quickly to worst-case scenarios.  It is not enough to do well during the good times. The key to financial management success is building resiliency so you can weather the storms that inevitably arise.

Over the past few years, many default models overestimated credit defaults. Part of the reason was government policies that distributed huge amounts of cash to consumers and businesses alike. Monetary policy introduced tremendous amounts of liquidity, reducing spreads and allowing almost all businesses to refinance debt, build up cash reserves and fund new investments.  Startups were able to raise cash long before generating profits, and interest rates were at record low levels.  These trends were in place before the invasion of Ukraine, which accelerated them.

We are now entering a period of correction and a reset of correlations.  This reset will impact macroeconomic relationships, asset correlations and volatility, challenging portfolio managers and credit underwriters.  Model validation and more robust simulation and testing will become more important in this environment.

Defaults have been at multi-year lows, and some investors may have fallen into the same trap of complacency as central bankers.   Once the credit cycle turns, it is too late to adequately adjust your portfolio.  There are many good tools available to measure interest rate risk, liquidity and default risk. To be in line with industry best practices, board members and executives must extend their focus beyond regulatory compliance and take advantage of them.

About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 41,200 public firms in 76 countries that have an annualized one- month default risk of over one percent. The average index value since January 1990 is 14.21%.  Since November 2015, the Kamakura index has used the annualized one-month default probability produced by the KRIS version 6.0 Jarrow-Chava reduced form default probability model, a formula that bases default predictions on a sophisticated combination of financial ratios, stock price history, and macro-economic factors.

The KRIS version 6.0 models were developed using a data base of more than 2.2 million observations and more than 2,600 corporate failures. The forthcoming version of KRIS default probabilities uses more than 20 million observations and more than 7,000 corporate failures. A complete technical guide, including full model test results and parameters, is provided to subscribers. The KRIS service also includes a wide array of other default probability models that can be seamlessly loaded into Kamakura’s state-of-the-art enterprise risk management software engine, the Kamakura Risk Manager. Available models include the non-public-firm default model, the commercial real estate model, the U.S. bank model, and the sovereign model.  Related data includes credit default swap trading volume by reference name, market implied credit spreads, and prices on all traded corporate bonds traded in the U.S. market.  Macro factor parameter subscriptions include Heath, Jarrow, and Morton term structure models for government securities in the U.S., Germany, the UK, Canada, Spain, Sweden, Australia, Japan, Thailand, and Singapore.  All parameters are derived in a no-arbitrage manner consistent with seminal papers by Heath, Jarrow, and Morton, as well as Amin and Jarrow.  A KRIS Macro Factor Scenario Service subscription includes both risk neutral and “real world” empirical scenarios for interest rates and macro factors.

The version 6.0 model was estimated over the period from 1990 through the Great Financial Crisis and includes the insights of the entirety of that era. The 76 countries currently covered by the index are:  Argentina, Australia, Austria, Bahrain, Bangladesh, Belgium, Belize, Botswana, Brazil, Bulgaria, Canada, Chile, China, Colombia, Croatia, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Ghana, Greece, Hungary, Hong Kong, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Kuwait, Luxembourg, Malaysia, Malta, Mauritius, Mexico, Nigeria, the Netherlands, New Zealand, Norway, Oman, Pakistan, Peru, the Philippines, Poland, Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Tanzania, Taiwan, Thailand, Turkey, the United Arab Emirates, Uganda, the UK, the U.S., Vietnam and Zimbabwe.

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