Not Just A Virus Crisis

05/01/2020 10:12 AM

Not Just A Virus Crisis.
Kamakura Troubled Company Index Declines by 0.89% to 31.30%.
Credit Quality is at the 4th Percentile.

NEW YORK, May 1, 2020: The world’s attention has been focused on day- to- day updates about COVID-19: the number of positive cases and fatalities, questions about ending lockdowns, and news about vaccine development. All of these factors have translated into enormous swings in the market. A key part of the story is global credit conditions, which were already at the 14th percentile before the crisis started. Getting a handle on potential future defaults is dependent upon understanding the weaknesses that the virus crisis exposed.

These are indeed extraordinary times. The Federal Reserve bought $1.3 trillion of treasury debt in a single month. Everyone knew the Fed would come to the rescue, but how much rescue is needed and how much will create moral hazard? How much does intervention stabilize the markets and how much does it mask risk? Answers to these questions will emerge later. Our goal now is to examine the current metrics with a forward-looking bias so that we can anticipate and quantify the risks to come.

The Kamakura Troubled Company Index® stabilized with a small decline of 0.89% to 31.30% and remained at the 4th percentile. The index continued to be highly volatile, ranging during the month from 25.69% to 32.4%. The index reflects the percentage of 40,500 public firms that have a default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the close of April, the percentage of companies with a default probability between 1% and 5% was 22.38%, a decrease of 0.27% over the month. The percentage with a default probability between 5% and 10% was 4.81%, a decrease of 0.52%. Those with a default probability between 10% and 20% amounted to 2.7% of the total, a decrease of 0.1%; and those with a default probability of over 20% amounted to 1.41%, unchanged from the prior month.

At 31.30%, the Troubled Company Index remained at the 4th percentile of historical credit quality as measured since 1990.

Among the 10 riskiest-rated firms listed in April, nine were in the U.S, and one was in Luxembourg. The riskiest- rated company in our coverage universe was Entercom Communications Corporation (NYSE:ETM), with a one-year KDP of 66.55%, up 11.65% over the past month. Six of the 10 riskiest companies were in the energy sector. We had 15 defaults in our coverage universe, with 10 in the U.S. and one each in Australia, Chile, Luxembourg, Singapore, and the UAE. The breadth of the failures show the global ramifications of current market conditions.

The Kamakura expected cumulative default curve for all rated companies worldwide narrowed slightly, with the one-year expected default rate decreasing by 0.62% to 3.47% while the 10-year rate decreased by 0.69% to 21.46%. The expected 10-year cumulative default rate has been higher than the prior peak during the credit crisis for two consecutive months.

By Martin Zorn, President and Chief Operating Officer, Kamakura Corporation

An important part of the current credit story is not the increase in the Troubled Credit Index or the Expected Cumulative Default curve. These tools have been flashing yellow warning signals for some time. Rather, the COVID-19 pandemic is the pin that has pricked the credit bubble building for the past several years. Concern was masked by the low one-year default probability, narrowed spreads, and a robust refinancing market that allowed firms to pretend and extend without defaulting.

After a long period of complacency, we believe that the current crisis is the trigger event. The Federal Reserve, as well as global central banks, are riding to the rescue. Governments are spending as needed to compensate for a mandated shut- down of the global economy. In my home state of Hawaii, our unemployment rate is now higher than it was during the Great Depression. Government intervention is creating a short- term floor for adverse economic consequences, but one of the unintended consequences may be masking longer- term risk in some cases.

Extraordinary times call for new tools to understand and manage longer- term risk. Over the past two weeks, we hosted two very successful webinars on the valuation of corporate bonds and performance attribution. These seminars can be found here:

These tools both help investors identify risk and allow them to understand the drivers of the risk, including default, recovery, and liquidity preferences. This is a challenging endeavor, since risks can be easily hidden in plain sight as a result of government intervention and markets often overstate them, given the difficulty traditional risk tools have in distinguishing real problems from false positives.

About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 40,575 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 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. 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 riskneutral and “real world” empirical scenarios for interest rates and macro factors.

The version 6.0 model was estimated over the period from 1990 to May 2014 and includes the insights of the entirety of the recent credit crisis. 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 Kamakura Corporation
Founded in 1990, Honolulu-based Kamakura Corporation is a leading provider of risk management information, processing, and software. Kamakura was recognized as a category leader in the Chartis Report, Technology Solutions for Credit Risk 2.0 2018. Kamakura was named to the World Finance 100 by the editor and readers of World Finance magazine in 2017, 2016 and 2012. In 2010, Kamakura was the only vendor to win two Credit Magazine innovation awards. Kamakura Risk Manager, first sold commercially in 1993 and now in version 10.0.5, is the first enterprise risk management system for users focused on credit risk, asset and liability management, market risk, stress testing, liquidity risk, counterparty credit risk, and capital allocation from a single software solution. The KRIS public firm default service was launched in 2002. The KRIS sovereign default service, the world’s first, was launched in 2008, and the KRIS nonpublic firm default service was offered beginning in 2011. Kamakura added its U.S. Bank default probability service in 2014.

Kamakura has served more than 330 clients with assets ranging in size from $1.5 billion to $3.0 trillion. Current clients have a combined “total assets” or “assets under management” in excess of $26 trillion. Its risk management products are currently used in 47 countries, including the United States, Canada, Germany, the Netherlands, France, Austria, Switzerland, the United Kingdom, Russia, Ukraine, South Africa, Australia, China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, Singapore, Sri Lanka, Taiwan, Thailand, Vietnam, and many other countries in Asia, Europe and the Middle East.

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