“I see many similarities to 2006 and 2007 in the credit markets today,” Edward I. Altman, professor at the Stern School of Business at New York University, said when speaking recently at the 2013 Asset and Risk Allocation conference in New York. A highly respected researcher of the high-yield bond markets, Altman took the audience through his analysis of current economic conditions and his outlook for corporate and sovereign credit markets. Altman presented his new research on sovereign default risk. “When you think about credit risk today, sovereign default risk is the number one concern for investors, while the corporate bond market has been relatively benign since 2008–2009.”
Altman outlined what he believes are the major risks for 2013 (and beyond) that could negatively affect both bond and equity markets:
- Size of the Fed’s balance sheet, the impact on the money supply, and the potential for inflation. Altman is most concerned about the size of the Fed’s balance sheet (now at $3 trillion), current monetary policy, and the Fed’s ability to monitor both the growth rate in US econmy and lending by banks so that it can change policy at just the right time. “The big question is whether Bernanke can take his foot off the accelerator in a measured and reassuring way that doesn’t trigger a sharp response by the markets,” Altman said. Referencing the credit booms of 2006 and 2007, he emphasized that banks are in fact lending today, but to the most risky borrowers because of the low level of interest rates. And, the old familiar CLO machine is cranking again, climbing from $0 in transactions three years ago to $50 billion last year, with $100 billion expected for 2013. If bank reserves get churned into the system through lending, inflation would likely follow.
- LBO and covenant-lite risk. Companies are paying big prices for LBOs, and unfortunately covenant-lite indentures are again becoming the norm. In 2007, LBOs were valued at 6x debt/EBITDA. Today it’s more like 9.2x (2012). “Lenders are not requiring collateral or covenants to protect themselves in case of credit deterioration,” Altman warned. “We seem to have forgotten the hard lessons of 2008.”
- Contagion between debt and equity markets. The correlation between risky debt (high yield and distressed) has historically been 0.4–0.5. Recently it’s been closer to 0.8. There’s no place to hide in risky assets today. Negative info for Europe affects markets in the United States in same way.
And there is plenty more for investors to worry about. Altman is concerned about the lack of adequate (and liquid) collateral behind many of the bonds in the global financial system, municipal bond default risk, paralysis in our political system, and uncertainty about geopolitical risks worldwide.
Measuring Risk Tolerance in Bond Markets
“High Yield spreads (as measured by yield-to-maturity spreads or option-adjusted spreads) are a good measure of the risk tolerance in markets at a given point in time,” Altman said. These spreads, which peaked in December 2008 at over 2000 bps, have been below the historical average of 525 bps the last three years as the Fed continues to pump liquidity into markets. Altman said perhaps spreads should be even tighter given actual recent default rate history (1.6% in 2012 versus 4% for the historical average) with abnormally high recovery rates. Even though absolute yields on high yield are near their all-time lows (currently 6.5%) money is still flowing into the asset class because of the perceived low default risk.
Altman urged investors to keep their eyes open for situations in which risk perceptions get out of line with reality. For example, “2009, in my mind, was the ‘year of the anomaly,’ where we had incredibly high spreads and high default risk expectations in the corporate bond market and at the same time returns that were as high as they’ve ever been,” Altman said. In 2009 actual defaults turned out to be 11%, the second highest default risk in history, yet markets were forecasting even higher risk (Altman’s forecast was 14% and Moody’s was 20%). Because of this misperception of risk, the average rate of return for high yield bonds was 60% in 2009, distressed debt was 90% and a diversified portfolio of defaulted bonds gained over 100%.
Altman is predicting 2.8% default risk for next year, but said he could again be on the high side because his models don’t include the unprecedented liquidity that the Fed is pumping in the system. In the United States today, even marginal companies are borrowing at low rates. In Europe, the banks aren’t lending, but the marginal companies are able to issue debt in the in the public markets. More cause to worry.
A New Way to Look at Sovereign Debt Risk — from the Bottom Up
Most investors in the past have tended to look at macroeconomic data to assess the default risk of sovereign debt — but Altman argues this is not enough. In addition to the macro picture, we should also be looking at the health of the private sector. A bottom-up analysis of the private sector gives a better, more forward-looking view of the sovereign. It makes sense because the healthier companies help support the sovereign — they can pay more taxes (to a limit), hire more people, and contribute to the overall well-being of a country.
As proof of the rationale for looking at the private sector, Altman recapped a debate that occurred at the World Bank after the Asian financial crisis of 1997–98. The debate was about where to put the blame for the crisis — on the:
- flight of western capital, that caused the Thai Baht and other currencies to devalue which devastated those with non-local currency debt, or
- basic fundamentals, competitiveness and risk profiles of the companies in southeast Asian countries.
Using Altman’s Z-Score model, the World Bank showed that if you calculate the Z-score for every listed company in Asia, you would have found that South Korea had the lowest composite Z-score predicting its default (recall South Korea received a $50 billion bailout from the IMF at the time).
In his current analysis, Altman applied the same approach to 10 European countries (Sweden, the United Kingdom, Netherlands, Ireland, Germany, France, Spain, Italy, Portugal, and Greece), the United States, and Australia using Z-Metrics — the third generation of Altman’s Z-score model — and calculated the probability of default (PD) for all the listed companies in the industrial sector for these selected countries from 2008 to 2012. (The study excludes the financial sector which Altman admits is a shortcoming. He’s working to including banks and other financials in the next study — stay tuned!) As of 30 June 12, the analysis showed that in the next five years:
- 25% of Greek companies (i.e., 75th percentile) had a probability of default of 47% or higher
- 25% of Spanish companies had a PD of 25% or higher
- 25% of Italian companies had a PD of 25.4% or higher
- 25% of Portuguese companies had a PD of 32.3% or higher.
- 25% of US companies had a PD of 11.2% or higher
- 25% of Australian companies had a PD of 9.7% or higher
- 25% of the companies in Ireland had only 7.3% PD — the lowest PD for the industrial private sector than any other country in the study!
Finally, Altman compared the five-year implied PDs from sovereign CDS spreads with the 75th percentile of the industrial private sector from 2008 to the present. What was most interesting was how the two models are converging today, but from different directions. In other words, the CDS market says European sovereign debt of the periphery countries is becoming less risky and the Z-metrics model (the bottom-up model based on the private sector) says the sovereign debt is becoming more risky. Only time will tell.
“Over the next five years the PD for Spain and Italy is over 25%, and for Portugal it’s 40%. In addition the Z-metrics model shows a sharp upturn in risk for France recently, with its PD climbing towards 12%. It is clear that all these European countries haven’t cured their fundamentals and growth is a very distant prospect, especially given the strong euro and lack of needed labor reforms. If you want a short, short France,” Altman said. The professor loves their food, but not their bonds.
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