News & Notes from IACC


Corporate Default Risk Rises as Global Growth Worries Mount

Kamakura Troubled Company Index Increases by 2.39% to 12.85%. The index reflects the percentage of 39,000 public firms that have a default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

The Kamakura Troubled Company Index ended May at 12.85%, an increase of 2.39% from the end of April. The index reflects the percentage of 39,000 public firms that have a default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the close of May, the percentage of companies with a default probability between 1% and 5% was 10.05, an increase of 1.5% from the end of April. The percentage with a default probability between 5% and 10% was 1.91%, an increase of 0.6%. Those with a default probability between 10% and 20% amounted to 0.67% of the total, up 0.2%, and those with a default probability of over 20% amounted to 0.22%, up 0.09% from a month earlier.

The index ranged from 10.31% on May 3 to 13.19% on May 13 as volatility increased to 288 basis points.  

At 12.85%, the troubled company index now sits at the 42nd percentile of historical credit quality as measured since 1990. Among the 10 riskiest-rated firms listed in May six are in the U.S., with one each in Australia, Belgium, Great Britain and Spain. Pier 1 Imports (PIR:NYSE) moved ahead of Global Eagle Entertainment Inc. (ENT:NASDAQ) as the riskiest-rated firm, with a one-year of KDP of 49.91%, up 11.65% from the prior month. During the month there were six defaults in our coverage universe, with three in the US and one each in Korea, Switzerland, and Taiwan.

The Kamakura expected cumulative default curve for all rated companies worldwide showed increases at both the short and the long ends, with the one-year expected default rate increasing by 0.32% to 1.43% and the 10-year rate increasing by 0.82% to 14.4%.

By Martin Zorn, President and Chief Operating Officer, Kamakura Corporation

The increased risk revealed by the Kamakura Troubled Company Index reflects uncertainty in global growth expectations resulting from trade and tariff concerns. In the U.S., planned retail store closings already top 7,150, and tariff wars could inflict even more pain on this vulnerable industry segment. Interestingly, however, while the S&P 500 fell 6.6% in May, the VIX remained flat. Government bond yields fell to 20-month lows, reflecting a flight to safety. Yield on the German 10-year bund fell to -0.201%, an all-time low, while the Dutch 10-year bond turned negative for the first time since September, 2016.

The Expected Cumulative Default Rate has been showing signs of increase as we look across the term structure. Using the Expected Cumulative Curve, we can extract these one-year-forward expected defaults:

Forward One-Year Cumulative Default Rate
May 2019     1.43%
May 2020     1.86%
May 2021     1.30%
May 2022     1.21%

During the Great Recession from December 2007 through June 2009, the one-year KDP averaged 2.24% and peaked at a little over 4%. It fell as low as 0.50% during the expansionary phase. The forward one-year default rate confirms that we are late in the credit cycle, but it also implies that the coming economic slowdown with increasing defaults will not be as bad as the last cycle and will be relatively shallow, given the quick improvement in the implied rates for 2021 and 2022.

It is interesting to see how the average one-year KDP (Kamakura Default Probability) has moved relative to the credit cycle. As a proxy for the credit cycle, I have substituted the Federal Reserve’s Senior Loan Officer Opinion on Bank Lending Practices, which uses tightening and loosening standards as a stand-in for the expansion or downturn stages of a cycle.  

Here we see that the average one-year KDP during the loosening period following the recession fell to 0.61% for rated firms and 0.96% for non-rated firms. Looking at the tightening period beginning in fourth quarter of 2018, the average one-year KDP for rated firms reached 1.16%, while the average one-year KDP for non-rated firms was actually slightly better, at 1.15%. Studying the movement in default probabilities by sector, country, and counterparty provides insight into the risks late in the credit cycle. We will be publishing more research on this topic soon.

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