CDS Spread to Default Risk

7/29/2019 CDS Spread to Default Risk

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Robert J. Grossman, Managing Director

Macro Credit Research

October 2012

Debt Defaults and SovereignRisk: CDS Spreads as aLeading Indicator

CFA Society Austin / San Antonio


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CDS Spreads as a Leading

IndicatorPredictive Performance DuringThe 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)


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www.fitchratings.com

Why Study CDS Spreads?

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

0

500

1,000

1,5002,000

2,500

3,000

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

Monoline REIT Home Builder

Property-Sensitive Sectors CDS Spreads

(bps)

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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)

Assumptions underlying this formula:

Fixed (rather than stochastic) recovery rate

Risk-neutrality (i.e., no risk premium beyond compensation for EL)

Probability of Default (1 yr) = CDS spread (annualized) /Loss Severity

2% = 1.20% / 60%

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Mixed Performance in Signaling Eventual Defaults

M Months; T Time of credit event

Source: Fitch Ratings, Fitch Solutions, ISDA

CDS Predictiveness of Credit Events Varies by Sector

0

1,000

2,000

3,000

4,000

5,0006,000

7,000

8,000

Months Prior to Credit Event

Corporates (18 Credit Events)Financial Institutions (6 Credit Events)Monolines (3 Credit Events)

(bp)

1-year PD (T12M)

Monolines: 63.8%

Corporates: 22.9%

Financial Institutions: 3.3%

2-year (Cumulative PD)

Monolines: 21.9%

Corporates: 9.9%


1-year PD (T6M)

Monolines: 83.1%

Corporates: 45.5%


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(bps)


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0

200

400

600

800

1,000

1,200

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

REIT Home Builder

REIT and Homebuilders: False Positive?


REIT and Homebuilders CDS Spreads and Implied PDs

First Peak (Homebuilder)

Spread = 385 bps

Implied PD = 6.4%

Rise in implied PD, but no credit events in year following the peak

PD for REITs increased by a multiple of 30xfrom trough to peak

(bps)

Second Peak (REIT)

Spread = 1,154 bps

Implied PD = 19.2%

Second Peak (Homebuilder)

Spread = 481 bps

Implied PD = 8.0%

First Peak (REIT)

Spread = 409 bps

Implied PD = 6.8%

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


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

thus, senior debt obligations continued to perform, despite weakened condition

Financial Services CDS Spreads and Implied PDs

0

100

200

300

400

500

600

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

Banks Insurance(bps)

First Peak (Banks)

Spread = 427 bps

Implied PD = 7.1%

Peak (Insurance)

Spread = 487 bps

Implied PD = 8.1%

Second Peak (Banks)

Spread = 247 bps

Implied PD = 4.1%

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

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


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)

U.S. Broker-Dealer CDS Spreads by Entity

0100200300400500

600700800

Goldman Sachs Group Merrill Lynch & Co., Inc. Lehman Brothers Holdings Inc.

Morgan Stanley Bear Stearns Companies Inc.(bps)

March 2008

CDS spreads = 274 bps

Implied PD = 4.6%

October 2007

CDS spreads = 68 bps

Implied PD = 1.1%

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Similar Signals, Different Outcomes

Note: For background and assumptions on peak cohorts above, please see Fitchs report CDS Spreads and Default Risk: Interpre ting the Signals


A priori challenge of interpreting spikes in CDS spreads

Industry spreads of> 1,000 bps not necessarily predictive of default risk

Challenge in Differentiating Elevated Default Risk from False Positives

Sample

Entities in

Sample

CDS Spreads

(bps)

Implied One-

Year PD (%)

Credit Events

in Ensuing

Year (%)

Corporates, One Year Prior to Experiencing Credit Events 18 1,374 22.9 100

U.S. Real Estate Investment Trusts Peak Spreads (December 2008) 29 1,154 19.2 0

Financial Institutions, Three Months Prior to Experiencing Credit Events 6 552 9.2 100

European Insurance Companies Peak Spreads (March 2009) 17 507 8.5 0

U.S. Homebuilders Peak Spreads (November 2008) 8 481 8 0

Financial Institutions, One Year Prior to Experiencing Credit Events 6 199 3.3 100

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Performance as Relative Indicators

M Months; T Time of credit event


Identifying Outliers Within High-Yield

0

1,000

2,000

3,000

4,000

5,000

6,000

Months Prior to Credit Event

Corporate Credit Events

High-Yield Index

(bp)

12 Months Prior

Credit Events: 1,375 bpHY Index: 772 bp

Differential: 603 bp

24 Months Prior

Credit Events: 305 bp

HY Index: 307 bp

Differential: (2) bp

Six Months Prior

Credit Events: 2,732 bp

HY Index: 1,018 bp

Differential: 1,714 bp

(bps)

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CDS Spreads as a Leading

Indicator

Where Do We Go From Here?


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Corporate Spreads Tighter Since Crisis Peaks

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

Global Corporates CDS Spreads

(bps)

0

100

200

300

400

500

600

Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12

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%

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Bank Spreads Remain Volatile, Well Above Pre-crisis Lows

Possible Drivers: Bail-in / reduced support

Regulatory changes

Eurozone stresses


Global Banks CDS Spreads

(bps)

0

50

100

150200

250

300

350

400


Peak (Mar 09)

Spread = 335 bps

PD (5 yr) = 25.0%

Current (Sep 12)

Spread = 212 bps

PD (5 yr) = 16%

Low (Dec 06)

Spread = 12 bps

PD (5 yr) = 1.0%

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Banks vs. CorporatesSeveral Crossovers

Corporates widened more than banks during the credit crisis (08 09)

Reversal over the recent pastpotential disintermediation for large corporates?


Global Corporates vs. Banks CDS Spreads

(bps)

0

100

200

300

400

500

600


Global Corporates Global Banks

Low (5 yr PD)

Corp = 4.4% (Feb 07)

Banks = 1.0% (Dec 06)

Peak (5 yr PD)

Corp = 34.9% (Dec 08)

Banks = 25.0% (Mar 09)

Current (Sep 12) 5 yr PD

Corp = 12.9%

Banks = 16.5%

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Bank Widening Particularly Evident in Europe

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)

European CDS Indices Banks and Corporates

(bps)

050

100150200250300

350400450500


Bank Index Value Corp Weighted Index Value

Current (Sep 12) 5 yr PD

Corp = 13.1%

Banks = 20.8%

Second Peak (5 yr PD)

Corp = 20.5% (Oct 11)

Banks = 33.4% (Nov 11)

First Peak (5 yr PD)

Corp = 32.6% (Dec 08)

Banks = 20.2% (Mar 09)

Low (5 yr PD)

Corp = 3.9% (Jun 07)

Banks = 0.7% (Dec 06)

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Sovereign CDS Volatile Since September 2008

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

Developed Sovereigns (ex. Greece) CDS Spreads

0

50

100

150

200

250

300



(bps)

Current (Sep 12)

Spread = 127 bps

PD (5 yr) = 10.2%

Second Peak (Nov 11)

Spread = 280 bps

PD (5 yr) = 21.2%

First Peak (Feb 09)

Spread = 197 bps

PD (5 yr) = 15.4%

Low (Jun 07)

Spread = 2 bps

PD (5 yr) = 0.2%

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Distressed Spread Levels: Greece vs. Ireland

Both reached distressed trading levels of 1,000 bps

Ireland was an apparent false positive subsequent sharp tightening of spreads

Greece vs. Ireland CDS Spreads

0200400600800

1,0001,200

1,4001,6001,8002,000

Dec-07 Aug-08 Apr-09 Dec-09 Aug-10 Apr-11 Dec-11 Aug-12


Greece (Hellenic Republic of) Ireland (Republic of)(bps)

Current (Sep 12)

GreeceSpread = 11,775 bpsPD (5 yr) > 100%

IrelandSpread = 295 bpsPD = 22%

Jul 2011

Ireland hits 1250 bps

PD (5 yr) = 69%

Feb 2009 PD (5 yr)

Ireland = 29%

Greece = 20%

Jun 2010

Greece hits 1000 bps

PD (5 yr) = 60%

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Future Events that May Affect Sovereign CDS

Oct. 1819 European Council (banking union, Greece)Nov. 1213 Eurogroup/ECOFIN (EU finance ministers)Dec. 34 Eurogroup/ECOFIN (EU finance ministers)Dec. 1314 European Council (vote on banking union)December Single-supervisory mechanism plan

Spring 2013 Italian elections

Sept. 2013 German elections

Several Decision Points Within Eurozone

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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 aversionof 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, Augu st 2009

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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

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www.fitchratings.com 9/26/2012

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 nota 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.


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CDS Spread to Default Risk

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