Sunday, November 17, 2013

Corporate Risk Models Are Broken

This important article has been linked in quite a few places but the only one I remember is LearnBonds.
From the Financial Times:
Half a decade of loose monetary policy in the US has produced a curious reaction in the analytical frameworks that attempt to forecast the rate at which the country’s companies will default – the models have gone mild.
Even as leverage and signs of credit deterioration build up in the system, most of the models used by investors to forecast the probability of companies not paying back their debt have yet to predict a rise in corporate defaults. Other models, analysts say, have been forecasting a spike in defaults that never materialises.

Concerns are now mounting that the analytical frameworks, which underpin many investment decisions, are becoming increasingly useless when it comes to measuring risks lurking in the corporate bond world and wider financial system.

“Any model that you put together is completely destroyed by what’s going on in the central banks,” says Rob Smalley, US credit strategist at UBS and a veteran bond analyst.

Ultra-low interest rates and the Federal Reserve’s bond-buying programme, known as quantitative easing, have helped US companies roll over their debt obligations in the dollar market at ever lower rates. At the same time, investors who are desperate for returns have little option but to keep buying increasingly weaker-quality debt.

Money has subsequently poured into corporate loans and bonds in recent years, with the result that many companies have been able to increase their borrowing from exuberant markets.

More than $225bn of “covenant-lite” loans, or loans that come with fewer protections for lenders, have been sold so far this year, according to S&P Capital IQ. That figure eclipses the $100bn issued in 2007 and means a majority of new leveraged loans – 55 per cent – are “cov-lite”.

The availability of easy money combined with yield-hungry investors has enabled companies to stave off defaults for the past five years by refinancing their debt. 

New bonds sold by companies supported only by fragile balance sheets, and with ratings deep in junk territory, rose to a record $38bn this year, according to data from Dealogic.

Still, corporate default rates and negative bias, which indicates companies’ potential for downgrades, have dropped to multi-year lows. The default rate now stands at 2.3 per cent, below the 4.5 per cent historical average, according to Standard & Poor’s....MORE
HT: LearnBonds