Follow the Cash

04/02/2024 07:34 AM

NEW YORK, April 2, 2024: Global markets posted gains in the first quarter, with U.S. markets leading the way.  While uncertainty around rate cuts and geopolitical tensions remained, growing confidence in a soft landing and excitement around artificial intelligence pushed issues higher.  Support broadened beyond the Magnificent 7, although strength remained concentrated among large-cap to mega-cap stocks. All U.S. sectors gained except real estate, which we will discuss below.  Fixed income gained in the leveraged loan and high yield sectors, but declined for Treasuries and investment-grade bonds.

Last month we asked whether fundamentals still matter.  Defaults are increasing, especially for U.S. leveraged loans. Interest coverage ratios have been deteriorating since the rate hikes began. One key question is which companies are most at risk from continued higher interest rates.  Adding to the complexity are global demographic shifts and the many behavioral and industry changes that have occurred in the post-Covid environment.

Credit spreads suggest a no-default or low-default environment.  ICE BofA US Corporate Index option-adjusted spread stayed below 100bps for most of March posting some of the lowest levels observed post GFC. At the riskiest side of the IG spectrum, the BBB rallied to end March with OAS standing at 117bps. Note that according to SIFMA, BBB represented 38% of trading volume across all corporate bonds in the US during last year (up from 27% in 2013).

Figure 1: ICE BofA BBB US Corporate Index Option-Adjusted Spread

At the same time, our numbers show a slowly increasing number of defaults.  So far this year, we have seen 15 defaults in January, 16 in February and 18 in March.  Most have been in leveraged firms in sectors at risk from higher interest rates and tighter credit underwriting, limiting their ability to roll over and refinance debt.  One problem sector is healthcare, where many firms became leveraged in response to low growth and low margins.  One wonders whether the slow increase in defaults represents the classic story about turning the heat up on a frog in boiling water, rather than a sudden spike that is quickly noticed.

Real estate represents a more obvious credit risk, especially for office properties and rent- controlled residential budlings in New York.  Higher interest rates and their effect on cap rates reduces the value of cash flow, while inflation, maintenance costs and office vacancies reduce net operating income. This puts pressure on real estate firms, the CMBS markets, the banks with significant CRE exposures, construction companies and others in the real estate supply chain. Table 1 shows the riskiest 10% of office REIT issues, which we use as a proxy for this segment.

Table 1- REIT-Office 1-year KDP

The conclusion is that we will have higher rates longer than expected (as we have stated on numerous occasions last year).  In this environment, cash is king, since we do not expect the market appetite for refinancing rollover debt to leveraged borrowers will change.  Firms that: a) have a limited ability to adapt to economic and industry changes, b) are highly leveraged, or c) have low growth and margins will see increasing defaults.  The increase in defaults may occur slowly enough to appear as idiosyncratic events, but the risk that they can cause a systemic contagion is always present.

Contemporaneous Credit Conditions
The Kamakura Troubled Company Index® closed the month at 9.13%, up 0.17% from the prior month. The index measures the percentage of 42,500 public firms worldwide with an annualized one-month default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the end of March, the percentage of companies with a default probability between 1% and 5% was 6.77%. The percentage with a default probability between 5% and 10% was 1.27%. Those with a default probability between 10% and 20% amounted to 0.80% of the total; and those with a default probability of over 20% amounted to 0.29%.  For the month short-term default probabilities ranged from a low of 8.97% on March 6 to a high of 9.23% on March 26.

Figure 2: Troubled Company Index® — March 28, 2024

At the end of March, the riskiest 1% of rated public firms within the coverage universe included 11 companies in the U.S. and 1 in France. Last month’s riskiest rated firm, JOANN Inc. filed for bankruptcy on March 18.  This month the riskiest firm is WW International (WW:NASDAQ) (formerly known as Weight Watchers), with a one-month KDP of 33.64%, up 29.92% for the month.

 Table 2: Riskiest Rated Companies Based on 1-month KDP – March 28, 2024

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate down 0.05% at 0.63%, with the 10-year rate down 0.08% at 9.78%.

Figure 3: Expected Cumulative Default Rate — March 28, 2024

About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 42,100 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 14.16%.  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. Available models include the non-public-firm default model, the U.S. bank model, and the sovereign model.

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.

About SAS
SAS is the leader in analytics. Through innovative software and services, SAS empowers and inspires customers around the world to transform data into intelligence. SAS gives you THE POWER TO KNOW®.

Editorial contacts: