What does credit default pricing tell us about the cycle?

Credit risk is the risk that companies do not repay their debts. This risk can be measured and traded.

CDX IG is an index comprising the 125 most liquid single name Credit Default Swaps (CDS) in the investment grade space in the US. The most commonly traded tenor point is 5 years and the index is refreshed by the provider every 6 months to maintain maturity and liquidity profile of the underlying names. We are currently on series 31 (meaning the index has been running in one form or another since 2002-2003).

The index is quoted in terms of basis points and a quote represents the annual cost of insuring a notional amount of the underlying assets (as a simple approximation). For example; with CDX IG NA currently trading at 78bps (0.78%) an investor paying to insure US$10mn for 5 years would pay US$78,000 annually. In return for this insurance premium they would be made whole (minus the recovery rate) in the event of any defaults during the period, proportionate to the size of the constituent. On the flip side, the seller of such a contract would receive US$78,000 annually whilst being on the hook for the above obligations.

These indexes are quoted continuously, and as one may take either side of the trade, most participants are speculating on changes in the costs of insurance while a minority of participants are hedging a genuine need. As such they become a good (and often the best) indicator for market perceptions of broad credit risk.

This year, CDX IG has spiked decisively from multi year lows and exhibited a particularly aggressive move on the tail end of the October sell off.

The reasons for this move and our attention to it are twofold. Firstly, the idiosyncratic story of General Electric (GE) which is in the spotlight currently. GE is arguably the stalwart ‘large safe US corporate’ in investor minds. In recent months a number of factors including an accounting scandal and considerable leverage on the balance sheet have created questions about the continuation of GE as a going concern.

This concern has been reflected in the company’s cost of capital. GE has been frozen out of the commercial paper market, its bonds trade at tangibly higher yields than other investment grade corporates and its equity has fallen to a post Global Financial Crisis low. Naturally GE debt is also a constituent of the CDX IG NA index.

There is a broader, macro point of interest. Credit spreads can provide investors with an indication of where we are in the equity market cycle.

Economic cycles are at their root a credit phenomenon. Recessions arise as increasing confidence in the continuation of growth leads to the relaxation of lending standards and the prioritisation of growth over risk management. Capital flows to increasingly less productive avenues until a tipping point is reached. Perhaps inflation begins to erode margins in borrowers with little pricing power, or interest rates rise as central banks look to take some steam out of an economy running at full pelt. Regardless, interest costs begin to pressure corporate earnings and a repricing of risk occurs.

The market for credit risk insurance is the most sensitive barometer of this repricing of risk. Credit spreads have historically flagged rising stress in the underlying economy 6 months or more ahead of the penny dropping for equity markets. The recent move in CDX IG may be simply a function of idiosyncratic GE stress. It may however presage the beginnings of something more fundamental. We will keep a close eye on events.

Our concern is increased by deteriorating mix within the US corporate credit market. The lowest rung of the investment grade universe (BBB rating) has ballooned in issuance in the United States relative to any other time in history.

Companies are happy to receive an ‘investment grade’ stamp by the thinnest of margins as long as it makes their debt eligible for large pools of conservative capital to invest in, and the low cost of borrowing that results.

The potential for similar balance sheet stresses in other large investment grade corporates would be accurately reflected in rising prices of CDX IG, making it a legitimate tool in a sophisticated multi-asset portfolio.

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By |2018-11-23T12:55:49+00:00November 23rd, 2018|Cerno Capital, Cerno Capital Posts, Credit, General Investment|

About the Author:

Michael began his investment career at GLG Partners, the hedge fund, in 2006 where he focused on the Basic Materials and Industrials sectors. He worked as an equity research analyst at Citi (2011-2017), initially covering Mining & Steel (2011-2015) and latterly European Chemicals (2016-2017). Michael graduated from the University of Nottingham with an BA (Hons) in Industrial Economics.