Politics Meet Economics
NEW YORK, March 2, 2023: February 24 marked the one-year anniversary of the war between Russia and Ukraine. The inflationary pressure of the war, combined with the inflationary pressure of fiscal responses to the Covid pandemic, continue to play out on a global basis. The most optimistic among us hoped that interest rates were approaching a level that would bring inflation under control. But the reality is, the causes of inflation are complex, and the fight to bring it down to target levels will inevitably result in a bumpy ride. As portfolio managers consider interest rate, liquidity, and default risk, they must continually update their models to reflect the implications of emerging data.
Contemporaneous credit conditions declined slightly as the Kamakura Troubled Company Index closed February at 7.63%, up 0.17% from the prior month. The index measures the percentage of 41,500 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 February, the percentage of companies with a default probability between 1% and 5% was 5.68%. The percentage with a default probability between 5% and 10% was 0.97%. Those with a default probability between 10% and 20% amounted to 0.67 of the total; those with a default probability of over 20% amounted to 0.31%. Short-term default probabilities ranged from a low of 7.22% on February 15 to a high of 7.63% on February 28.
Figure 1: Troubled Company Index — February 28,2023
At the end of February, the riskiest 1% of rated public firms within the coverage universe included eight companies in the U.S. and one each in Luxembourg, and the UK. The riskiest rated firm was Audacy Inc, (AUD:NYSE), with a one-month KDP of 21.80%, down 0.61% from the previous month. There were six defaults in the KRIS coverage universe in February, with two each in Brazil and the U.S. and one each in Norway and the UK.
The three-year default probability provides a more forward-looking view than the one-month probability. Commercial delinquencies remain low by historical standards, so the low level of short-term risk makes sense. As we look further out on the curve, the impact of higher interest rates and the rollover risk of existing debt have a greater impact on credit quality. This can be seen in Figure 2.
Figure 2: 3-Year term Default Probabilities – U.S. Market, February 28, 2023
Table 1 below shows the riskiest companies, based on the three-year default probability. The table measures the likelihood of default over a longer time horizon, which we think is an appropriate view in the current environment. The ability to examine the term structure of default is an advantage of the KRIS data.
Table 1: Riskiest 1% of Rated Companies Based on 3-Year KDP – February 28, 2023
The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate up 0.04% at 0.57% with the 10-year rate was up 0.29% at 10.24%. The three-year expected cumulative default rate rose to 3.38% which implies an increasing rate of defaults over the next few years.
Figure 3: Expected Cumulative Default Rate — February 28, 2023
Commentary
Stas Melnikov and Martin Zorn
SAS Institute Inc.
Inflation returned as the headline risk driving the markets this month. The markets reacted to the fears of rates rising faster and longer than expected a few weeks ago and concerns of a hard landing. While it remains premature to speculate about a soft landing, hard landing or no landing, it is clear that data points to the need to focus on the basics.
Early in my banking career, I was reminded that there are three rules to lending or investing. Rule one is to ensure the return of your capital, Rule two is to ensure is the return on your capital and Rule three is not to forget Rule one.
Before we focus on interest rate risk, let us focus on what is happening in the credit markets. Figure 4 shows an uptick in consumer delinquencies at commercial banks. Figure 5 provides a view of discretionary consumer credit, i.e., credit card debt. This chart shows both a higher uptick in delinquencies and a pronounced age differential. Auto delinquencies show a similar trend, with younger borrowers more adversely impacted by higher rates and costs. This cohort also makes up a disproportionate percentage of the subprime auto market–which partially explains the default by American Car Center this week.
Figure 4: Delinquency Rate on Consumer Loans, All Commercial Banks
Figure 5: Consumer Credit Cards 90+ days Delinquent – WSJ/TransUnion
Commercial debt is holding up largely because consumer spending continues to be strong, despite higher interest rates and the depletion of Covid-era savings. There is also a shift occurring within consumer spending between goods and services consumption.
On the interest rate front, 6-month Treasury Bills yield 5%, the highest rate since 2007. The yield on all U.S. investment-grade bonds is now 5.5%. With the bounce in the Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) Index, it is easy to assume that rates will continue to rise and that inflationary pressure will remain longer than expected only a few weeks ago. The markets will also pay close attention to the Fed’s 2-percent target, which could come under political pressure, given the agency’s dual mandate.
All these factors provide a reason to revisit the fundamentals. Interest rate models need to be robust. Liquidity risk models must also be robust. Despite rising rates, deposits have been sticky so far. But let us not forget politics as regulators begin to look at the low rates banks continue to pay. Regulatory pressure or consumer spending could cause a shift in deposit behavior at some point, resulting in a rapid increase in bank liquidity risk.
With an expectation of continued rising rates, foreign exchange risk and mark-to-market risk also increase. Finally, default risk in this environment will increase with time as higher borrowing costs impact financial performance and make it more difficult for companies to roll over debt in less accommodating credit markets.
Risk management in this environment requires robust data and dynamic models that can recognize changes in interdependencies and measure behavioral changes as they happen, not after they happen. New data and risk factors will be needed to adequately assess these emerging risks.
SAS is well-positioned to provide all the analytics necessary to answer the myriad of questions today’s challenges pose.
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 14.33%. 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.
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
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Editorial contacts:
- Martin Zorn – Martin.Zorn@sas.com
- Stas Melnikov – Stas.Melnikov@sas.com