Defaults, revisited
by Sam Jones
On Tuesday we noted the current chaos in fixed-income and CDS markets which seems yet to have worked through into equity.
With severe recession now firmly on the horizon, bond markets are anticipating a huge surge in default rates. The broad consensus is that junk rated credits will fare, relatively speaking, worse. One commenter noted on the site yesterday:
…there has been rating deterioration across the board over the last decade, it has been more pronounced in sub-investment grade. Investment grade is still typically single and A, but sub-investment grade now means single B whereas it used to mean BB.
And indeed, it’s the itraxx Crossover index which is seeing some of the most dramatic moves right now, compared to the investment grade iTraxx Europe. The Crossover is currently at an all time wide:
The big moves in the iTraxx crossover index are interesting when seen historically, rebased against moves made by the iTraxx Europe:
Relatively speaking, the iTraxx crossover and iTraxx Europe indices have diverged quite markedly - to the casual observer it looks like there is something of a correlation crisis at work. Either one of the indices was mispriced or one of them is mispriced.
1. It may be that, looking backwards, just as too many AAA structured finance bonds were thought too safe (and thus paid too little) so investment-grade corporates were “overrated” and are now being proved to be actually much riskier. The investment grade iTraxx Europe, which has never existed through a recession, is thus adjusting to a more historically accurate correlation between it and the junk-grade crossover.
2. The IG index also contains a large number of financials: you might consider what’s going on in this whole sector an idiosyncratic event, and thus likely to pull the IG index out of historical line.
3. Or it may be that the iTraxx Europe is the correctly priced index, and it’s the Crossover which will have to adjust.
The crisis in financials has indeed been behind the “disproportionate” rise in the iTraxx Europe, but to tackle point 2, the trouble in that sector is not an idiosyncratic issue but a systemic one: one which will spread.
Defaults/rising default risk in financials should be seen as a precursor to a wave of defaults elsewhere. Only in the coming months will the real effects of the crunch start to be felt on the broader economy, and with it, the broader corporate universe: to which the iTraxx Crossover is most exposed. Assuming then, some kind of historical correlation between the two indices still holds, the Crossover will move much wider yet.
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There might be a third take. A bit of a get out, but no less relevant. The modelling and pricing assumptions around CDS and CDS indices - both iTraxx Europe and Crossover - are totally inadequate in the current crisis.
Default modelling has relied on historical data going back, typically, over the past twenty years. The last banking crisis like this that we faced was in 1930.
The pricing of credit is broken.
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