Troubled Markets

05/01/2022 07:34 PM

Troubled Markets
Kamakura Troubled Company Increases by 3.31% to 8.39%
Credit Quality Declines to the 77th Percentile

NEW YORK, May 2, 2022: The markets are increasingly focused on earnings misses, aggressive language from the Federal Reserve about interest rates and inflation, and the short-term outlook for economic growth. The cover headline of The Economist was “The Fed That Failed: How inflation humbled America’s central bank.”

The Kamakura expected cumulative default models have been flashing cautionary signals for quite a while as 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 conditions dropped 19 points to the 77th 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 April at 8.39%, compared to 5.08% 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 April, the percentage of companies with a default probability between 1% and 5% was 6.89%, an increase of 2.40% from the previous month. The percentage with a default probability between 5% and 10% was 1.03%, an increase of 0.59%. Those with a default probability between 10% and 20% amounted to 0.35% of the total, representing an increase of 0.23%; and those with a default probability of over 20% amounted to 0.12%, an increase of 0.09% over the prior month.  Volatility increased, with default probabilities ranging from 4.64% on April 4 to 8.39% on April 29.

Figure 1: Troubled Company Index — April 29, 2022

Among the 20 riskiest-rated firms listed in April, six were in the United States, five were in China (including Hong Kong) two in Sweden, and one each in the UK, India, Ireland, Italy, Mexico, Norway and Switzerland. The riskiest-rated firm was Exela Technologies, with a one-month KDP of 32.94%, up 8.99% from the previous month.  There were no defaults in the Kamakura coverage universe in April.

Table 1: Riskiest-Rated Companies Based on 1-Month KDP – April 29, 2022

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate up 0.35% at 2.03% and the 10-year rate down 1.41% at 17.74%.

Figure 2: Expected Cumulative Default Rate — April 29, 2022

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

The Federal Reserve has a dual mandate: to foster economic conditions that achieve stable prices and to maximize sustainable employment.  They employ some of the brightest economists and modelers in the world.  How did they get inflation so wrong, and what does that imply for their ability to get it right now?  Federal Reserve chairman Jerome Powell said last month “We have had price stability for a very long time and maybe come to take it for granted”.

When inflation picked up last year, most investors and analysts dismissed it as dislocations from the pandemic.  We will put aside the debate about whether the political and health response in the U.S. was effective.  Most believed that when the pandemic receded, so would inflation.  Did the Fed and other central banks put too much credence in their models?  Isn’t this the same path they followed for the banking system, resulting in stress tests and a myriad of new regulations?  Why did they not stress test their own models and simulate tail effects, such as the forces of inflation now rampant in the economy?  The Fed kept repeating that they had the tools to combat inflation, yet they seemed to lack the will to use them.   Even after they concluded their models were wrong, they have been slow to respond.

Defaults have been at multi-year lows, and it is an obvious concern that investors, as they chased yield over the past few years, may have fallen into the same trap of complacency as central bankers.   Unfortunately, even the yields on leveraged loans or securitized assets do not adequately cover the cost of losses when defaults occur.  We have seen over and over that regulatory compliance alone will not prevent major losses.  It was this approach that lured many into Bank TRUPS (Trust Preferred Securities) a little over a decade ago, on the assumption that they were highly rated, and issuers were highly regulated.  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. Following the crowd is not a good explanation to provide to your investors or board of directors if you are wrong.

About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 40,500 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 14.24%.  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.

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 10.1, 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 non-public 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 $7.0 trillion.  Current clients have a combined “total assets” or “assets under management” in excess of $38 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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