Commentary on Political Economy

Wednesday, 24 June 2020

Credit defaults are soon to sweep across Europe
Like the US Central bank stimulus cannot defy the financial laws of gravity governing defaults ROBERT SMITH

An odd thing is happening in US corporate debt markets. Widely followed measures of default risk suggest increasing calm — just as bankruptcies are becoming more frequent and ruinous for creditors. Credit-default swaps (CDS) are derivatives that behave like insurance contracts, protecting holders against the risk that a company does not repay its debts. As such, indices of these swaps are a guide to the health of corporate bond markets. If the average price of buying protection against default rises, it points to greater financial stresses ahead. The two main US CDS indices spiked in late March as the scale of economic disruption from the spread of coronavirus became apparent. The cost of buying the baskets of swaps referencing investment-grade and junk-rated companies more than trebled to 150 basis points and 880 bps respectively.  These extreme moves notably delivered a $2.6bn windfall for hedge fund manager Bill Ackman, who had perfectly timed a big short against corporate debt using these indices.

 But just after this, the US Federal Reserve launched a package of stimulus measures that calmed bond markets and caused the average cost of default protection to tumble. The investment-grade index now trades at less than 80bp and its junk-rated equivalent at a little over 500 bps.  Yet while the Fed has been able to ease concerns around corporate bonds at an aggregate level, even the most powerful central bank in the world cannot defy the financial laws of gravity governing defaults. What CDS traders euphemistically call “credit events” — when a company fails to make a payment on its debt, triggering a payout on the swaps — are happening with alarming regularity. Bankruptcies of heavily indebted companies including retailer Neiman Marcus and car rental group Hertz have led to nine US credit events this year, compared to four in the whole of 2019 and three in 2018. The high levels of payouts on these swaps indicate, moreover, that bondholders are expected to recover little of their money in many of these bankruptcy proceedings. After a credit event is called, the CDS market holds an auction to determine what the underlying defaulted bonds are now worth. A lower price leads to a higher payment on the swaps, based on the principle that holders of the swaps should be compensated if there is greater financial loss in an insolvency or restructuring. This process judged the bonds of bankrupt Texan oil company Diamond Offshore Drilling to be worth a little over 7 cents on the dollar last month, for example. Earlier this month retailer JCPenney’s debt was valued at less than 1 cent, implying a near-total wipeout for creditors. But while there is something of a dichotomy between the relative calm in US credit indices and the drama under the surface, the goings-on in European credit derivatives are downright uncanny.

 Government lockdowns to combat the spread of coronavirus have hit economies hard across Europe. But there has not been a single credit event in the European CDS market this year. The reason for this has little to do with any greater corporate resilience to economic shocks. Businesses in sectors long groaning under debt burdens are starting to fail, as they are in the US, despite unprecedented levels of government stimulus. Instead, the answer is partly technical. CDSs are written only against the debt of businesses with tradable bonds. In the US, a much wider variety of companies tends to tap public capital markets to raise debt. But in Europe all manner of businesses have collapsed with no bonds outstanding, such as rent-to-own retailer BrightHouse and Italian restaurant chain Carluccio’s. Recommended FT News Briefing podcast10 min listen Trump expands US immigration restrictions, Apple pivots away from Intel, inside Wirecard The other dynamic is legal. The US Chapter 11 process for corporate bankruptcies allows companies to keep operating, while typically handing control to creditors in an orderly fashion. When the writing is on the wall for American businesses, they tend to file sooner rather than later.

 Across Europe, meanwhile, different insolvency regimes lead to various outcomes, but the one thing most share is that they take more time than the US. Still, credit events will be coming to Europe sooner rather than later. For example, Dutch retailer Hema’s swaps are widely expected to be triggered in coming weeks because of a debt restructuring. Hema could yet be overtaken by Wirecard, the German payments group on the brink of insolvency after admitting for the first time the potential scale of a multiyear accounting fraud. Wirecard’s debt was judged investment grade less than a week ago. This should serve as yet another reminder that when financial gravity reasserts itself, the fall can be fast and hard.

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