Tuesday, February 26, 2008

The Short View: Default Fault Lines

(FT) A year ago, there was a historic opportunity to make money out of credit. The market had never paid you less to compensate for the risk that a company would default. To profit, you bought insurance against default.

Things have changed. Defaults have fallen, but the market is now prepared to compensate you generously for bearing the risk of a default. This is true of the market for cash bonds or for credit default swaps, which offer insurance against default; it is true from the most speculative credits to the safest triple-A rated companies; and it is true both in Europe and the US. But nobody wants to take on these risks. The market had it badly wrong a year ago. Has it now gone too far in the opposite direction?

Deutsche Bank's annual default study, now in its 10th year, suggests that it may have. Using average historic default rates, it works out what extra yield a credit needs to pay, compared with Treasuries, to compensate for default risk.

The spread that credit pays above the yield needed to protect against average default rates - called the "default spread premium" by Deutsche - is at its highest this decade for investment-grade credits.

The picture is more ambiguous for riskier credits, where, more in the US than Europe, default spread premiums are not as high as they were in 2002. They do, however, look generous.

Many analysts now say that the market has gone too far and that investment-grade credit is attractive to those with the patience to sit out the market turbulence for a few months.

Many credit market operators cannot be patient, as they themselves are heavily leveraged. Further, a recession might inflict defaults well above historical averages.

But it looks like now could be the time for big and patient investors (such as Warren Buffett) to start snapping up relatively good-quality credit.

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