3.2 MACROECONOMIC ENVIRONMENT
3.2.3 The credit cycle
Considering the importance of dynamic credit risk modeling, the analysis of the relationship between the two major indicators for credit risk, that is default rates and credit spreads, and the business cycle is central for the understanding of the risks associated with investing in corporate bonds.
Especially investors that tend to hold securities to maturity, investing in high yield, or running structured portfolios are concerned about avoiding defaults. While default rates generally are a function of the credit cycle outlined above, their current level is not necessarily reflected in credit spreads. In order to judge the attractiveness of the current spreads, one need to not only forecast the future direction of default rates, but also to see whether they are sufficient to cover potential future losses. The sensitivity of the corporate bond market to economic downturns depends particularly on the distribution of the credit quality of the issuers and on the ratio of cyclical companies to noncyclical companies.
The rating agencies provide the most accurate data on historical default rates. Based on their data, empirical studies by Wilson (1997), Nickell et al.
(2000), Bangia et al. (2002), Allen and Saunders (2003), and others suggest that default rates tend to be higher in recessionary periods. As might be expected, default rates usually peak at the end of recessions and fall when the economy is expanding. A closer look at history shows that default rates reached their highest levels in the 1930s, peaking at 9 percent in 1932. Since then they have never come close to that level. From 1940 to 1970 they were extremely low, hardly ever exceeding 1 percent. Moody’s themselves note that in the 1973 recession, the default rate was close to zero because only the best issuers had been able to access the capital markets in the previ- ous years. In the early 1990s and at the beginning of the new millennium default rates rose significantly, reaching their peak at about 4 percent. Thus, the default cycle has mirrored the business cycle very well in the past 15 years. Yet one difference is not reflected in this figure. On a dollar- weighted basis, the 2002 default rate for speculative grade issuers was nearly twice as high as in 1991, causing painful losses for many investors.
Furthermore the 2002 default rate for US investment grade issuers reached more than 1 percent on an issuer-weighted basis and almost 3 percent on a dollar-weighted basis. This is substantially above the 30-year average of the investment grade default rate, which is about 25 basis points. Clearly, investment grade defaults are supposed to happen very infrequently.
Intuitively, the described long-term pattern contrasts with the much more cyclical behavior of credit spreads. Yet it should be noted that a large part of this deviation has to be attributed to changes in the databases of the rating agencies and the average quality of recent new issuance. When the database contains more investment grade companies, default rates natu- rally tend to be lower, and vice versa. Furthermore, historical data on default rates does not only reflect the broad credit cycle, but also changes in companies’ preferences towards bank debt and corporate issuance. When
banks’ lending standards are particularly restrictive, especially companies with a lower credit quality may prefer to finance their business by issuing corporate bonds. For the high-yield market there is empirical evidence that the average maturity of outstanding debt is correlated with the probability of default. In other words, default probability changes over the life of a bond. While at the date of issuance the company has sufficient capital, there is often considerable uncertainty about the viability of the business model and future economic success. Together with the 1990/91 recession the enor- mous volume of junk bonds issuance that took place in the late 1980s is responsible for the peak in default rates in 1991. Consequently, default rate data provided by the rating agencies is not a very pure indicator of credit conditions through time.
Fama and French (1989), Stock and Watson (1989), and Chen (1991) examine the correlation between credit spreads and the business cycle.
They find empirical evidence that corporate bond spreads are good predic- tors of future economic growth. Based on empirical data from 1933 to 1997, a recent study by Koopman and Lucas (2003) reveals two different types of cycles. On the one hand, there is a cycle with a frequency of about 6 years, where a positive correlation between credit spreads and default rates, and a negative correlation between spreads and economic growth can be observed. On the other hand, a second cycle with a duration of about 11 years shows a positive link between spreads and business failures, and a negative correlation between GDP growth and both spreads and default rates. However, constraining the analysis on the post Second World War era no significant correlations between credit spreads, default rates and the business cycle could be found (see Figure 3.16).
With regard to the above-mentioned problems, rating migrations seem to be a more reliable indicator of changes in credit quality than default rates. Given that the risks of downgrade as well as default vary over time, the question is whether credit spreads compensate investors adequately.
Since the sample for the calculation of rating transition matrices is much broader than for default rates, they are less likely to be biased by changes of the rating agencies’ universe. To measure changes of credit quality over time, the ratings drift, that is the number of upgrades minus the number of downgrades, as a proportion of the total number of entities rated, can be a valuable indicator. A sample of high-quality issuers, however, will tend to have more downgrades than upgrades, and vice versa. Hence, variations of the ratings drift partly reflect changes in average credit quality over time.
As one would expect, credit spreads tend to rise when the ratio of upgrades to downgrades becomes worse (see Figure 3.17).
The question, however, is, whether the credit spreads widen enough to compensate investors sufficiently for the deterioration of average credit quality that is reflected by a falling ratings drift. While predicting the direc- tion of spread changes may help to make money on a mark-to-market basis,
Figure 3.16 Baa corporate spread over treasuries versus trailing 12-month default rates
Source: Moody’s 0.0
0.5 1.0 1.5 2.0 2.5 3.0
(%)
3.5 4.0 4.5 5.0
1970 1974 1978 1982 1986 1990 1994 1998 2002 0 50 100 150 200 250 300 350 400 450
Moody's trailing 12 m default rate – all corporate issuers (lhs) Moody's Baa corporate spread versus treasuries (rhs)
Figure 3.17 Moody’s ratings drift ([upgrades – downgrades]/number of rated issuers) versus Moody’s Baa corporate spread over treasuries
Source: Moody’s 50
100 150 200 250 300 350 400 450
1997 1998 1999 2000 2001 2002 2003
–20 –15 –10 –5 0
(%)
5
10 Moody's Baa corporate spread over treasuries
Moody's ratings drift (inverted rhs)
it is not adequate for buy-and-hold investors. They have to estimate the magnitude of the spread widening that corresponds to an observed deterio- ration of credit quality. Hence, the focus is purely on credit risk, while credit spreads also incorporate liquidity premia, and are influenced by technical factors and market sentiment.
The spread needed to compensate for default risk depends upon future default rates, recovery rates and ratings transition probabilities. The rating agencies publish their forecasts of future default rates based on historical data. Usually required spreads come out significantly lower than current spreads for investment grade companies. For high yield, however, observed spreads tend to be too low, given the actual risk of default. While over the long term buy-and-hold strategies may earn an excess return over government bonds for pure investment grade portfolios, this strategy is not appropriate for high-yield portfolios. Here, investors need to focus much more on the process of selecting the right companies and avoiding the blowup names. A look at historical data shows that market spreads tend to overshoot at the end of credit cycles, especially in the wake of a recession.
For example, even if the historically high default rates of 1990/91 had per- sisted over the following years, investors should have required a BBB credit spread of only 115 bps for medium-term bonds. At that time the average market spread for BBB-rated issues, however, peaked at more than 180 bps.
Consequently, the market was much too bearish in 1991. Conversely, in 1997, at the beginning of the severe bear market for credit, spreads were too tight for the period of downgrades and credit blowups that followed. Note that these observations apply for bonds with a maturity of roughly 4 years.
While the cushion is not as comforting as for shorter maturities, even at the long end the spread levels reached in recessions provide sufficient protec- tion, even when assuming that default rates stay high for a sustained period of time.