The Risks of Curing Inflation

10/03/2022 09:33 AM

Kamakura Troubled Company Index Increases by 0.89% to 8.53%
Credit Quality Declines to the 95th Percentile

 NEW YORK, October 3, 2022: The four phases of the credit cycle are expansion, downturn, repair, and recovery.  Market liquidity driven by fiscal and monetary support have driven a long-term expansion that survived the Covid shock, but is now threatened by inflation, higher interest rates and the removal of that unprecedented accommodation. Last week the Bank of England intervened in the British bond market to reduce the risks to certain pension funds.  Published reports indicated that the rising rates threatened to create a margin call against derivatives used by those funds.  Severe downturns are often caused when a shock to the market acts as an accelerant of rising risks.  The key question now is whether central banks can tame inflation while being nimble enough to protect against an inadvertent shock to the markets.

In July, the Kamakura Troubled Company Index® began using the new Version 7.0 default probability models from Kamakura Risk Information Services. Credit conditions moved down 4 percentage points to the 95th 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 September at 8.53%, compared to 7.64% the month before.  The index measures the percentage of 41,500 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 end of September, the percentage of companies with a default probability between 1% and 5% was 6.51%.  The percentage with a default probability between 5% and 10% was 1.09%.  Those with a default probability between 10% and 20% amounted to 0.66% of the total; those with a default probability of over 20% amounted to 0.27%.  Short-term default probabilities ranged from a low of 7.51% on September 16 to a high of 8.53% on September 30, 2022.

Figure 1: Troubled Company Index — September 30, 2022

At the end of September, 15 of the riskiest rated public firms worldwide were in the United States, with two in Luxembourg and one each in France, Germany, Italy, and the United Kingdom.  The riskiest rated firm was Loyalty Ventures Inc. (LYLT:NASDAQ), with a one-month KDP of 37.57%, down 11.42% from the previous month.  Despite the good overall credit quality globally, there were five defaults in the KRIS coverage universe in September with one each in the Cyprus, Japan, Korea, United Kingdom, and the United States.

Table 1: Riskiest Rated Companies Based on 1-Year KDP – September 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 0.02% at 0.67%, and the 10-year rate down 0.13% at 8.28%.  Note that the 10-year expected cumulative default rate in November, 2008–at the height of the Great Financial Crisis–was 11.44%.  Since July 2022, the Expected Cumulative Default Rate has also been reported using the KRIS Version 7.0 default models.

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

Commentary
Stas Melnikov and Martin Zorn
SAS Institute Inc.

The market has seen central banks shift their focus from providing liquidity and economic support to combating effects of the Covid pandemic to honing in almost exclusively on interest rates and inflation.  Central bankers were slow to realize that inflation was not “transitory,” and are now plowing full speed ahead in an attempt to curb it.  The most immediate effects have been an increase in volatility, but also a great deal of uncertainty in the markets and a breakdown of historical correlations.  This last risk is not only critical for modelers, but a fundamental risk posed by current central bank actions.

How turbulent were markets in September?  Let’s start with the fixed income markets.  The ICE BofAML MOVE index, which tracks implied volatility of one-month treasury options, marked a new post-Covid high on September 28th (the day of the Bank of England intervention) with the print of 158.99.  That nearly matched the spike on March 9, 2020, where it closed at 163.  It is worth noting that in 2020, the spike was a one-day event quickly moderated by the decisive central bank intervention, whereas current levels of fixed income volatility are persistent and are starting to approach conditions last seen in 2009.

Risk assets have been stressed as well, but nowhere near the levels of the fixed income markets.  While S&P 500 had its third consecutive negative quarter (for the first time since 2009), volatility levels are much more muted by comparison.  Credit spreads have risen moderately but are still well in line with their historic average, confirming the robust credit conditions indicated by the Troubled Company Index.

Another notable highlight was a new low for the 10Y-2Y CMT spread, which hit 0.51 on September 23rd.  This level of the curve inversion has not been seen for over 20 years.  Historically, there is a high correlation between the inverted yield curve and the recessionary environment that follows.

If the reasoning behind the Bank of England’s intervention is correct, the hedges put in place by the pension funds should have protected against risk, especially interest rate risk.  But it appears not to have worked, resulting in the intervention.  It is already clear that central banks will raise rates to bring inflation back in line, even if it causes a recession.  But are they monitoring the financial market plumbing carefully enough to pivot and prevent any major breaks that could become a contagion–or turn into a systemic catalyst that causes a sudden surge in defaults?

While forecasting “known-unknowns” is always difficult, it is possible to become more focused in your analysis and identify sectors that are more prone to default.  In Figure 3, we disaggregate the Expected Cumulative Default data to focus on industries that are more vulnerable, as well as changes to future default risks over the past three quarters.  For example, the risks in energy, while still high over the next three years, have moderated compared to consumer discretionary goods.  This is intuitive in an environment of rising interest rates and increased concerns over a recession and job losses.

Stress testing, reverse stress testing and techniques like oversampling tail risk are very appropriate tools in the shifting economic environment, especially with the changing relationships across risk factors.  Prudent risk management practices will help practitioners navigate through the current credit cycle.

Figure 3: Distribution of Expected Cumulative Default Probabilities by Industry

About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 41,500 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 14.41%.  Since July 2022, the Kamakura index has used the annualized one-month default probability produced by the KRIS version 7.0 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 7.0 models were developed using a data base of more than 4 million observations and more than 4,000 corporate failures.  A complete technical guide, including full model test results and key 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, Kamakura Risk Manager.  Available models include the non-public-firm default model, the U.S. bank model, and the sovereign model.  Related data includes 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 yields in Australia, Canada, France, Germany, Italy, Japan, Russia, Singapore, Spain, Sweden, Thailand, the United Kingdom, and the United States, plus a 13-country “World” model.  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 7.0 model was estimated over the period from 1990, through the Great Recession and ending in February 2022.  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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