Unmasking Potential Credit Risks:

09/04/2023 08:05 PM

Are You Prepared if Defaults Accelerate?

NEW YORK, September 5, 2023: Markets backed off in August, with the S&P 500 down 1.59% as inflation concerns raised questions about the direction and timing of future rate hikes and the global impact of the slowing Chinese economy.  The S&P International 700 fell 4.08%, led by declines in Asian markets.  Energy was the only sector that was up for the month.

There were 12 defaults in our coverage universe during the month, with five in the U.S.,   two each in China and the U.K. and one each in Ireland, Japan and Thailand.  Consumer and business insolvencies in Canada surged to levels not seen in a decade.  Market sentiment believes that the Federal Reserve will pull off a soft landing.  Our commentary will consider the potential credit risks and how to prepare for them.

Contemporaneous credit conditions declined slightly in August, with the Kamakura Troubled Company Index® closing the month at 8.55%, up 0.26% from the prior month. The index measures the percentage of 42,100 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 August, the percentage of companies with a default probability between 1% and 5% was 6.22%. The percentage with a default probability between 5% and 10% was 1.20%. Those with a default probability between 10% and 20% amounted to 0.80% of the total; those with a default probability of over 20% amounted to 0.33%. Short-term default probabilities ranged from a low of 8.17% on August 7 to a high of 8.58% on August 22.

Figure 1: Troubled Company Index® — August 31, 2023

At the end of August, the riskiest 1% of rated public firms within the coverage universe included 12 companies in the U.S.  The riskiest rated firm was Cano Health Inc. (NYSE:CANO), with a one-month KDP of 49.09%, up 44.06% for the month. Cano Health is a primary care provider that went public in 2020 through a SPAC deal. 

Table 1: Riskiest Rated Companies Based on 1-month KDP – August 31, 2023

The term structure of default provides more insight into future movements than a point in-time view.  The shape of the curve in Figure 2 is insightful, much in the same way that analysts use yield curve differentials to drive strategies.  Uncertainty about the future is clearly evident in the difference between the four-year and two-year levels of default probability, which is as high as it was prior to the Great Financial Crisis.

Figure 2:  Cumulative Default Differences – U.S. Market, August 31, 2023

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate up 0.10% at 0.70%, with the 10-year rate down 0.01% at 8.79%.

Figure 3: Expected Cumulative Default Rate — August 31, 2023

Stas Melnikov and Martin Zorn
SAS Institute Inc.

The role of risk management is to simulate and evaluate financial risks and identify their potential impacts in order to avoid them, hedge them or profit from them. To be successful, the simulation processes must be robust, and the action plans clear. Failure to simulate possible outcomes and develop a well-crafted plan–or even understand the firm’s risk appetite–can result in significant losses or failure.

The macroeconomic environment appears stable, with many economies proving more resilient than expected.  Sentiment remains positive, albeit with a wary eye towards inflation and interest rates, as well as global geopolitical risks.  Market volatility has been subdued, suggesting investor comfort with current conditions.  This has led many investors to focus on individual companies and sectors.  In Figure 2 we looked at the cumulative differences in expected default rates and saw signs that risks, especially default risks, may be hiding in plain sight.

Debt levels have been rising, as can be seen in Figure 4 below.

Figure 4: All Nonfinancial Sectors Debt – Federal Reserve Board

Source: U.S. Federal Reserve;

The nonfinancial corporate-debt-to-GDP ratio is higher than it was before the pandemic.

Credit card balances are growing, banks are shrinking their balance sheets and regional banks are being downgraded as deposits continue to flee.  Yet credit volatility continues to collapse, though uncertainty about the future remains high.

In the current market environment, it is extremely important to focus on individual company characteristics, as “idiosyncratic risk” tends to blow up during times of distress.  You can look at this risk as diversifiable if you believe your portfolio is diversified and you have strong concentration risk controls in place.  What is more difficult is to identify which of these individual defaults or risks can be a trigger for a contagion.

We advocate using additional data and models to reduce the unexplained component, which is typically equated to idiosyncratic risk, and to reduce exposure to–or at least test–the risk that a single event can create a contagion.  Over the next months, we will be testing the wealth of default, spread and risk data that is contained in the SAS® KRIS® system to identify relationships, factors or correlations that can help reduce exposure to uncertainty shock.

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 14.25%.  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.

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