Corporate default risk models are broken

November 14, 2013 8:39 am

Corporate default risk models are broken

By Vivianne Rodrigues and Tracy Alloway in New York

Half a decade of loose monetary policy in the US has produced a curious reaction in the analytical frameworks that attempt to forecast the rate at which the country’s companies will default – the models have gone mild. Even as leverage and signs of credit deterioration build up in the system, most of the models used by investors to forecast the probability of companies not paying back their debt have yet to predict a rise in corporate defaults. Other models, analysts say, have been forecasting a spike in defaults that never materialises.

Concerns are now mounting that the analytical frameworks, which underpin many investment decisions, are becoming increasingly useless when it comes to measuring risks lurking in the corporate bond world and wider financial system.

“Any model that you put together is completely destroyed by what’s going on in the central banks,” says Rob Smalley, US credit strategist at UBS and a veteran bond analyst.

Ultra-low interest rates and the Federal Reserve’s bond-buying programme, known as quantitative easing, have helped US companies roll over their debt obligations in the dollar market at ever lower rates. At the same time, investors who are desperate for returns have little option but to keep buying increasingly weaker-quality debt.

Money has subsequently poured into corporate loans and bonds in recent years, with the result that many companies have been able to increase their borrowing from exuberant markets.

More than $225bn of “covenant-lite” loans, or loans that come with fewer protections for lenders, have been sold so far this year, according to S&P Capital IQ. That figure eclipses the $100bn issued in 2007 and means a majority of new leveraged loans – 55 per cent – are “cov-lite”.

The availability of easy money combined with yield-hungry investors has enabled companies to stave off defaults for the past five years by refinancing their debt.

New bonds sold by companies supported only by fragile balance sheets, and with ratings deep in junk territory, rose to a record $38bn this year, according to data from Dealogic.

Still, corporate default rates and negative bias, which indicates companies’ potential for downgrades, have dropped to multi-year lows. The default rate now stands at 2.3 per cent, below the 4.5 per cent historical average, according to Standard & Poor’s.

“We are only in the ‘fourth inning’ in terms of the default cycle, and as companies just keep refinancing and refinancing, the cycle will just keep getting postponed,” says Michael Collins, senior investment officer for Prudential Fixed Income.

“There’s still a lot of room for more leverage,” he adds. “Companies are taking advantage of these low borrowing costs to borrow and pay back shareholders.”

Big junk bond blow-ups have so far been few. When they have happened, their arrival has been well telegraphed and their impact relatively localised.

It strikes me that one of the things we’re doing is suppressing at-the-money risk and then adding to tail risks

– Matt King, credit strategist at Citigroup

“It strikes me that one of the things we’re doing is suppressing at-the-money risk and then adding to tail risks,” says Matt King, the well-respected credit strategist at Citigroup. He notes that some corporate credit models have been producing “false positives” – or a jump in defaults – that never actually occur.

By “suppressing day-to-day defaults through a lack of loan covenants – thereby encouraging people to take more risk – you give the impression that everything is hunky dory when beneath the surface it isn’t. This, I think, is part of the reason everyone’s default models have gone wrong – predicting a rise in defaults which then hasn’t happened.”

Others disagree that models are failing to incorporate risks lurking in the system.

“Maybe risk models are not properly showing risk because what the Fed has been doing is paying off,” says Sabur Moini, a high-yield bond portfolio manager at Payden & Rygel. “The US economy is reasonably all right and fundamentally things are better now than they were in the build-up to the crisis.”

Most credit analysts warn that the outlook for corporate defaults is now entirely dependent on the timing of the end of QE, the rise in interest rates and the health of the US economy when the Fed finally decides to scale back its stimulus.

Eileen Fahey, chief credit officer at Fitch Ratings, says: “We expect when interest rates go up there will be an increase in defaults. That’s the best we can do.”