2020 saw highest credit default events since 2009 - what about this year?
In times of crisis the credit default swap market springs to
life. We saw this in the Great Financial Crisis of 2007-2009, the
eurozone debt crisis of 2010-2012 and now the COVID-19 pandemic
that started in 2020 and is still with us. Investors require a
financial instrument that hedges credit risk and protects them
against defaults - CDS is specifically designed for such a
purpose.
Naturally, we would expect that the number of defaults rose during
2020. And indeed it did. Last year saw 20 CDS credit events across
the globe (including Europcar - auction next month). This is the
highest since 2009 and the second highest since the advent of the
auction mechanism in 2005 (previously all CDS were physically
settled bilaterally).
Source: IHS Markit/Creditex
But there are key differences between 2020 and 2009. First, the
scale: 2009 saw almost double the number of credit events (and the
38 total is adjusted for multiple events across the same company).
Secondly, the type of companies defaulting: 2020 saw multiple US
energy groups triggering events and was the first year that three
sovereigns defaulted (though Ecuador has the dubious distinction of
defaulting in both years). Thirdly, recovery rates were markedly
low: 9 of the 19 auctions held in 2020 produced results of less
than 10.
What does this tell us? It underlines that the recessions of
2008-2009 and 2020 were two very different beasts. The first was a
downturn precipitated by a financial crisis, with a restriction in
credit availability causing defaults across sectors. The recent
contraction was short and focused on specific sectors directly
affected by government lockdowns, alongside weakness in the US
energy sector.
The Great Financial Crisis was the catalyst for a decisive shift in
the Credit Cycle. Since 2009 we have seen the longest expansion
phase in the modern era. In March it seemed that it was coming to
an end and we were entering the downturn stage of the cycle. The
effectiveness of monetary policy was questioned in the face of a
concurrent demand and supply shock. But the world's major central
banks proved that they hadn't run out of ammunition, and their
liquidity support bolstered debt markets and stemmed the tide of
defaults.
Source: IHS Markit
The markets have confidence that this will remain the case in
2021 - the major CDS indices are now more or less back to where
they started the year. The first quarter - and possibly beyond -
promises to be difficult with the virus gaining strength across the
world. But the markets will look ahead to the likely recovery given
the rollout of vaccines currently underway.
A significant rise in inflation failed to materialise after QE was
introduced in 2008. The same scenario could play out again in the
coming years, supporting the secular stagnation/Japanification
theory. But if price levels rise - and more importantly,
expectations of prices rise - and this becomes entrenched, then we
could begin to see, finally, a shift in the credit cycle.
Regions with higher corporate leverage and lower economic growth
would inevitably suffer most in the credit markets. Asian debt may
fare better on these terms, but investors with international
exposure to the credit markets should keep a close eye on CDS
spreads for signs of distress and, of course, impending
defaults.
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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.