When you buy a credit product you take risk across three vectors—spread, default and term structure. Isolating where the asymmetry lies is what the Speaker focuses on.

In January, the asymmetry was in short defaults and short spreads, while from mid-March to mid-April it was long spreads and short defaults. Now, he thinks default optionality is even more asymmetric at various points in the term structure in the high-yield markets, specifically in Europe.

The spread between 2-year and 5-year iTraxx Crossover index, which measures the perceived risk of defaults by European companies with low credit ratings, is close to flat. But the expected loss curve is pretty steep, with defaults still mostly being priced later than 2 years from now.

Source: Bloomberg

The contingent probability of low defaults in the near term but a wave afterwards offers an extremely compelling trade construction. Because it can be hard to trade CDS on specific companies in times of market distress, the index is often bought as a generic hedge against default risk. You only need few defaults to occur in the next two years versus over five years to make money.

“Big companies are already failing,” said the Speaker. “The leverage unwind is incalculable.” He is bracing for a wave of defaults as lockdowns put severe pressure on liquidity.

Post-crisis recovery trajectories will vary by sector and business position. Those with longer recovery periods will have more stress on cash flows, leading to rising defaults through 2021. Some sectors, including autos and retail, were already suffering from disruptive trade tensions and anemic demand before the coronavirus. Fitch Ratings has revised its forecasts for European high-yield default rates to 5 percent in 2020 and 8 percent in 2021.

One of the participants wondered if companies could just limp along by virtue of low interest rates and central bank support. One in six US firms does not earn enough cash flow to cover interest payments on its debt. Such “zombie” borrowers could keep putting off the crunch if debt markets keep letting them refinance. For now, the ECB is only willing to support the high-quality end of the credit universe.


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