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Debt Defaults and Sovereign Risk: CDS Spreads as a Leading Indicator

CFA Society Austin / San Antonio


Robert J. Grossman, Managing Director Macro Credit Research October 2012

CDS Spreads as a Leading Indicator


Predictive Performance During The Crisis

Related Research:

CDS Spreads and Default Risk: A Leading Indicator?


(May 12, 2011)

CDS Spreads and Default Risk: Interpreting the Signals


(October 12, 2010)

Why Study CDS Spreads?


Property-Sensitive Sectors CDS Spreads
Monoline REIT Home Builder

(bps) 3,000
2,500 2,000 1,500 1,000 500 0 6/07 9/07 12/07 3/08 6/08 9/08 12/08 3/09 6/09 9/09 12/09 3/10 6/10 9/10

Pronounced volatility in CDS spreads during the crisis Spreads are one of the analytical tools used by Fitchs credit analysts (e.g., identifying outliers)
Source: Fitch Ratings, Fitch Solutions

www.fitchratings.com

9/26/2012 2

CDS Spreads as Risk Indicators


CDS spreads increasingly used for risk analysis
Converting spreads to probabilities of default (PD)
Assume 60% loss severity (i.e., 40% recovery rate) Annual CDS spread = 120 bps (prior example) Probability of Default (1 yr) = CDS spread (annualized) / Loss Severity

2%

1.20%

60%

Assumptions underlying this formula:


Fixed (rather than stochastic) recovery rate Risk-neutrality (i.e., no risk premium beyond compensation for EL)
www.fitchratings.com

9/26/2012 3

Mixed Performance in Signaling Eventual Defaults


CDS Predictiveness of Credit Events Varies by Sector
Corporates (18 Credit Events) Financial Institutions (6 Credit Events) Monolines (3 Credit Events)
1-year PD (T12M) Monolines: 63.8% Corporates: 22.9% Financial(bp) Institutions: 3.3% 2-year (Cumulative PD) Monolines: 21.9% Corporates: 9.9% Financial Institutions: 2.6% 1-year PD (T6M) Monolines: 83.1% Corporates: 45.5% Financial Institutions: 8.3%

(bps) 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0

Months Prior to Credit Event


M Months; T Time of credit event Source: Fitch Ratings, Fitch Solutions, ISDA

www.fitchratings.com

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REIT and Homebuilders: False Positive?


REIT and Homebuilders CDS Spreads and Implied PDs
(bps) 1,200 1,000 800 600
First Peak (Homebuilder) Spread = 385 bps Implied PD = 6.4%

REIT

Home Builder
Second Peak (REIT) Spread = 1,154 bps Implied PD = 19.2% Second Peak (Homebuilder) Spread = 481 bps Implied PD = 8.0%

400
200 0 6/07
First Peak (REIT) Spread = 409 bps Implied PD = 6.8%

9/07 12/07 3/08

6/08

9/08 12/08 3/09

6/09

9/09 12/09 3/10

6/10

9/10

Rise in implied PD, but no credit events in year following the peak
PD for REITs increased by a multiple of 30x from trough to peak
Source: Fitch Ratings, Fitch Solutions

www.fitchratings.com

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U.S. Banks & Insurance: Spreads Spiked Despite Support


Financial Services CDS Spreads and Implied PDs
(bps) 600 500 400 300
First Peak (Banks) Spread = 427 bps Implied PD = 7.1%

Banks

Insurance
Peak (Insurance) Spread = 487 bps Implied PD = 8.1%

200
100 0 6/07

Second Peak (Banks) Spread = 247 bps Implied PD = 4.1%

9/07 12/07 3/08

6/08

9/08 12/08 3/09

6/09

9/09 12/09 3/10

6/10

9/10

Extraordinary external support (e.g., government assistance, acquisition)


thus, senior debt obligations continued to perform, despite weakened condition
Source: Fitch Ratings, Fitch Solutions

www.fitchratings.com

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U.S. Broker-Dealers: Coincident, Not Leading?


U.S. Broker-Dealer CDS Spreads by Entity
(bps) 800 700 600 500 400 300 200 100 0
Goldman Sachs Group Morgan Stanley Merrill Lynch & Co., Inc. Bear Stearns Companies Inc.
March 2008 CDS spreads = 274 bps Implied PD = 4.6% October 2007 CDS spreads = 68 bps Implied PD = 1.1%

Lehman Brothers Holdings Inc.

As of October 2007, PD for sector was 1.1%... however, several events of distress over ensuing 12-month period Highest CDS spread observed during period of study: Morgan Stanley (700 bps in October 2008)
Note: CDS spreads in text boxes are aggregated for the broker-dealer sector as a whole and calculated as the average of the spreads of the individual entities Source: Fitch Ratings, Fitch Solutions

www.fitchratings.com

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Similar Signals, Different Outcomes


Challenge in Differentiating Elevated Default Risk from False Positives
Credit Events in Ensuing Year (%)
100 0 100 0 0 100

Sample Corporates, One Year Prior to Experiencing Credit Events U.S. Real Estate Investment Trusts Peak Spreads (December 2008) Financial Institutions, Three Months Prior to Experiencing Credit Events European Insurance Companies Peak Spreads (March 2009) U.S. Homebuilders Peak Spreads (November 2008) Financial Institutions, One Year Prior to Experiencing Credit Events

Entities in Sample 18 29 6 17 8 6

CDS Spreads (bps) 1,374 1,154 552 507 481 199

Implied OneYear PD (%) 22.9 19.2 9.2 8.5 8 3.3

A priori challenge of interpreting spikes in CDS spreads Industry spreads of > 1,000 bps not necessarily predictive of default risk
Note: For background and assumptions on peak cohorts above, please see Fitchs report CDS Spreads and Default Risk: Interpre ting the Signals Source: Fitch Ratings, Fitch Solutions, ISDA

www.fitchratings.com

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Performance as Relative Indicators


Identifying Outliers Within High-Yield
Corporate Credit Events High-Yield Index
Six Months Prior Credit Events: 2,732 bp HY Index: 1,018 bp Differential: 1,714 bp 12 Months Prior Credit Events: 1,375 bp HY Index: 772 bp Differential: 603 bp (bp) 24 Months Prior Credit Events: 305 bp HY Index: 307 bp Differential: (2) bp

(bps) 6,000 5,000 4,000 3,000

2,000
1,000

Months Prior to Credit Event


M Months; T Time of credit event Source: Fitch Ratings, Fitch Solutions, ISDA

www.fitchratings.com

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CDS Spreads as a Leading Indicator


Where Do We Go From Here?

Corporate Spreads Tighter Since Crisis Peaks


Global Corporates CDS Spreads
(bps) 600
500 400 300 200 100 0 Sep-06
Low (Feb 07) Spread = 53 bps PD (5 yr) = 4.4% Peak (Dec 08) Spread = 493 bps PD (5 yr) = 34.9% Current (Sep 12) Spread = 163 bps PD (5 yr) = 12.9%

May-07

Jan-08

Sep-08

May-09

Jan-10

Sep-10

May-11

Jan-12

Sep-12

Relatively strong cash positions and funding liquidity

Declining default rates after Dec 08 peak (Fitch-rated): 2009 (2.6%); 2010 (0.5%); 2011 (0.3%)
Global corporate default rate for H1 2012 (Fitch-rated): 0.33%
Source: Fitch Solutions

www.fitchratings.com

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Bank Spreads Remain Volatile, Well Above Pre-crisis Lows


Global Banks CDS Spreads
(bps) 400 350 300 250 200 Low (Dec 06) 150 Spread = 12 bps 100 PD (5 yr) = 1.0% 50 0 Sep-06 May-07

Peak (Mar 09) Spread = 335 bps PD (5 yr) = 25.0%

Current (Sep 12) Spread = 212 bps PD (5 yr) = 16%

Jan-08

Sep-08

May-09

Jan-10

Sep-10

May-11

Jan-12

Sep-12

Possible Drivers: Bail-in / reduced support Regulatory changes Eurozone stresses


Source: Fitch Solutions

www.fitchratings.com

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Banks vs. Corporates Several Crossovers


Global Corporates vs. Banks CDS Spreads
(bps) 600
Global Corporates
Peak (5 yr PD)

Global Banks

500 400
300 200 100 0 Sep-06 May-07 Jan-08 Sep-08
Low (5 yr PD) Corp = 4.4% (Feb 07) Banks = 1.0% (Dec 06)

Corp = 34.9% (Dec 08) Banks = 25.0% (Mar 09)

Current (Sep 12) 5 yr PD Corp = 12.9% Banks = 16.5%

May-09

Jan-10

Sep-10

May-11

Jan-12

Sep-12

Corporates widened more than banks during the credit crisis (08 09)
Reversal over the recent pastpotential disintermediation for large corporates?
Source: Fitch Solutions

www.fitchratings.com

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Bank Widening Particularly Evident in Europe


European CDS Indices Banks and Corporates
Bank Index Value (bps) 500 First Peak (5 yr PD) 450 Corp = 32.6% (Dec 08) Banks = 20.2% (Mar 09) 400 350 300 250 Low (5 yr PD) 200 Corp = 3.9% (Jun 07) 150 Banks = 0.7% (Dec 06) 100 50 0 Sep-06 May-07 Jan-08 Sep-08 May-09 Corp Weighted Index Value
Second Peak (5 yr PD) Corp = 20.5% (Oct 11) Banks = 33.4% (Nov 11)

Current (Sep 12) 5 yr PD Corp = 13.1% Banks = 20.8%

Jan-10

Sep-10

May-11

Jan-12

Sep-12

At 2011 peak, CDS indicated one-third of European banks would default within 5 yrs
Recent tightening, but spreads still imply one-fifth will default (over next 5 yrs)

www.fitchratings.com

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Sovereign CDS Volatile Since September 2008


Developed Sovereigns (ex. Greece) CDS Spreads
(bps) 300
Second Peak (Nov 11) Spread = 280 bps PD (5 yr) = 21.2%

First Peak (Feb 09) Spread = 197 bps PD (5 yr) = 15.4%

250 200
150 100 50
Low (Jun 07)

Current (Sep 12) Spread = 127 bps PD (5 yr) = 10.2%

Spread = 2 bps PD (5 yr) = 0.2%

0 Sep-06

May-07

Jan-08

Sep-08

May-09

Jan-10

Sep-10

May-11

Jan-12

Sep-12

Over past year, 5-yr. CDS-implied PD has roughly halved (~20% down to ~10%)
Difficult to backtest historically, given low incidences of sovereign default
Source: Fitch Solutions

www.fitchratings.com

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Distressed Spread Levels: Greece vs. Ireland


Greece vs. Ireland CDS Spreads
Greece (Hellenic Republic of) (bps) 2,000 1,800 1,600 Jun 2010 1,400 Greece hits 1000 bps PD (5 yr) = 60% 1,200 1,000 Feb 2009 PD (5 yr) 800 Ireland = 29% 600 Greece = 20% 400 200 0 Dec-07 Aug-08 Apr-09 Dec-09 Aug-10 Ireland (Republic of)

Jul 2011 Ireland hits 1250 bps PD (5 yr) = 69%

Apr-11

Dec-11

Current (Sep 12) Greece Spread = 11,775 bps PD (5 yr) > 100% Ireland Spread = 295 bps PD = 22%

Aug-12

Both reached distressed trading levels of 1,000 bps


Ireland was an apparent false positive subsequent sharp tightening of spreads
Source: Fitch Solutions

www.fitchratings.com

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Future Events that May Affect Sovereign CDS


Several Decision Points Within Eurozone Oct. 1819 Nov. 1213 Dec. 34 Dec. 1314 December Spring 2013 Sept. 2013

European Council (banking union, Greece) Eurogroup/ECOFIN (EU finance ministers)

Eurogroup/ECOFIN (EU finance ministers)


European Council (vote on banking union) Single-supervisory mechanism plan Italian elections German elections

www.fitchratings.com

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Drivers of Disconnects in Spreads vs. Fundamentals


Total return orientation of market participants
Focus on MTM value of CDS positions

Not necessarily reflective of longer-term credit risk

CDS pricing can be driven by factors not directly related to credit fundamentals
Liquidity conditions Counterparty risk Risk aversion of market participants (i.e., risk-neutrality assumption) Leverage (i.e., function of margin) As the markets came under increasing strain on account of the financial turmoil, liquidity in the CDS markets also began to dry up, raising doubts as to their value as an indicator of risk and funding costs.

European Central Bank, August 2009

www.fitchratings.com

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Risk Management Implications


CDS spreads can provide timely, market-based indicators of risk
Valuation, active portfolio management, and assessing funding conditions In some cases, spreads lead observable credit deterioration (Monolines) Useful informational content relative to other analytical tools (e.g., identifying outliers)

However, important to recognize the potential for:


False positives (REITs)
False negatives (Financial Institution credit events) Volatility

Costs of false positives


Expensive hedge Opportunity cost, if sold off positions

www.fitchratings.com

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Disclaimer
Fitch Ratings credit ratings rely on factual information received from issuers and other sources. Fitch Ratings cannot ensure that all such information will be accurate and complete. Further, ratings are inherently forward-looking, embody assumptions and predictions that by their nature cannot be verified as facts, and can be affected by future events or conditions that were not anticipated at the time a rating was issued or affirmed. The information in this presentation is provided as is without any representation or warranty. A Fitch Ratings credit rating is an opinion as to the creditworthiness of a security and does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. A Fitch Ratings report is not a substitute for information provided to investors by the issuer and its agents in connection with a sale of securities.
Ratings may be changed or withdrawn at any time for any reason in the sole discretion of Fitch Ratings. The agency does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security.
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS AND THE TERMS OF USE OF SUCH RATINGS AT WWW.FITCHRATINGS.COM.

www.fitchratings.com

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