Practical analysis for investment professionals
23 February 2016

The Altman Z-Score in Action: Is a Bubble Building in Global Credit Markets?

Posted In: Fixed Income

In the final installment of Edward Altman’s interview series with Larry Cao, CFA, they put the Altman Z-score to the ultimate test: How has it performed in the real world? Altman also gave his take on the state of global credit markets today.

For additional details of their conversation, please check out the two earlier installments in the series.

Larry Cao, CFA: There has been a lot of complaints about the credit rating agencies’ performance in the 2008 global financial crisis. Would people have benefited from using the Z-score?

Edward Altman: A better reference date could be 2007 because that would be before the crisis and [you might still be able to] hedge your risk. If you said in 2008 that more than 10% of the companies are going to go bankrupt, you would have been right, but it would have happened almost immediately, in 2009.

And the answer is, in 2007, the bond ratings of certain asset-related securities were much higher than they should have been. It was very much based on the easy liquidity and the benign credit cycle. At the same time, companies’ risks were increasing a lot, which was shown in the Z-score models very clearly. So what we’ve done is we look at the median 50th percentile score in 2007 and we found that the median score was 1.81, with a bond rating equivalent of B. That means that 50% of the firms were lower and actually fell into the “old” distressed classification.

It’s very profound to say that the users of the Z-score in 2007 could have done better than the people relying on the credit rating agencies.

Back in 2007, I was so convinced that a crisis was imminent that I actually wrote about it back then, saying that I felt that there was going to be a meltdown in [the] credit market. I felt it [was] going to come from corporate defaults, but it came from mortgage-backed securities. Corporates followed very soon and the default rate in 2009 was the second highest level ever, which could have been predicted based on 2007 data.

Where do you think we are in the credit cycle today?

I believe a bubble is building in the credit market today. A bubble is defined as unsustainable prices in an asset class. Most fixed-income products’ prices are limited on the upside to par, so bubble in fixed income is defined by default rate. High yield is my vantage point. A bubble is building when [the] default rate goes above [the] historical average. It will burst when a two standard deviation year — i.e., a greater than 10% default rate — happens. It has happened five times since 1990, far higher than the two times implied by a normal distribution.

We are in the eighth inning of the benign credit cycle today [in November 2015], but we may play extra [innings]. The longest benign cycle was seven years (measured in dollar-denominated default rates). We are now at the end of the sixth year of the current benign cycle. Central banks, the Fed, ECB, BOJ, and now PBOC will determine if the current cycle will last longer than seven years.

What alarming signs are you seeing?

The median Z-score in 2014 was 1.80, so today’s company is just about as credit worthy as 2007. We are quite vulnerable, particularly from firms rated B and CCC. [The] only thing that improved since 2007 was EBITDA/interest expense as interest rates have been so low. Debt is much higher. High-yield new issuance in the US and Europe each year since 2010 has increased significantly from 2007. Although CCC new issuance is lower than that of 2007 . . . , 15% of new issuance in the US this year remains CCC. Purchase price multiples on private-equity sponsored LBO deals (public to private) is also higher than that of 2007.

How will the maturity profile of leveraged debt play into this?

Peak of bond maturity is not until 2020–2021, but most defaults happen in years two to four from original issuance. The 1oth year is lowest. So I am not persuaded at all that when a bond matures is its most vulnerable.

That’s a very important finding. How bad do you do you think it will be when the bubble bursts this time?

I have been preaching for six to nine months now that a bubble is building. I don’t think we’ll see double digit default rates this time unless China unravels. But it will be dangerous enough and could even motivate a recession in the United States.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: Courtesy of Larry Cao, CFA.

About the Author(s)
Larry Cao, CFA

Larry Cao, CFA, senior director of industry research, CFA Institute, conducts original research with a focus on the investment industry trends and investment expertise. His current research interests include multi-asset strategies and FinTech (including AI, big data, and blockchain). He has led the development of such popular publications as FinTech 2017: China, Asia and Beyond, FinTech 2018: The Asia Pacific Edition, Multi-Asset Strategies: The Future of Investment Management and AI Pioneers in Investment management. He is also a frequent speaker at industry conferences on these topics. During his time in Boston pursuing graduate studies at Harvard and as a visiting scholar at MIT, he also co-authored a research paper with Nobel laureate Franco Modigliani that was published in the Journal of Economic Literature by American Economic Association. Larry has more than 20 years of experience in the investment industry. Prior to joining CFA Institute, Larry worked at HSBC as senior manager for the Asia Pacific region. He started his career at the People’s Bank of China as a USD fixed-income portfolio manager. He also worked for US asset managers Munder Capital Management, managing US and international equity portfolios, and Morningstar/Ibbotson Associates, managing multi-asset investment programs for a global financial institution clientele. Larry has been interviewed by a wide range of business media, such as Bloomberg, CNN, the Financial Times, South China Morning Post and the Wall Street Journal.

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