Moody's Doomsday Default Scenario Doesn't Play Out

At the beginning of this year Moody's (MCO) was taking a lot of heat for missing many financial company blow-ups, as well as the whole Mortgage-backed securities area where the grade AAA was clearly misapplied. So they forecast a scenario where speculative grade (BB and B) bond defaults to be higher than any time in history, including the Great Depression! Clearly, they would not be 'too optimistic' twice in a row. Seven months into this year, default are high, but around where they were in the 1990 and 2001 recessions, not near the 15% default rate anticipated. Default rates (annualized) were at around 10.7% in July, vs. 14.9% expected.


This is why the speculative grade market has rebounded so smartly this year. After a horrendous 2008, 2009 has been a strong year in spite of climbing default because prices anticipated the Moody's doomsday scenario. Total return to the High Yield Index (Merrill's Master II) is 40.0% through 8/28, well above last year's -26% debacle. Spreads between Treasuries and B rated bonds averaged an astronomical 13.1% at the beginning of this year, implying the market anticipated a doomsday scenario much worse than Moody's forecast at that time, or the Great Depression.

It seems likely that the risk premium actually manifested itself, too. That would be strange because usually there is no risk premium in High Yield bonds, as for many years the spread is about the same as the expected amortized loss rate, about 300 basis points. The High Yield index has done about as well as the Investment grade index since 1987, with significantly higher covariance with the business cycle, volatility, etc.

Spreads are currently about 5.8% for B rated bonds, which is well above historical norms, but way down from earlier this year. The worst-case scenario was baked in in January, default rates have not been as bad as they were expected, and things are now getting back to 'normal' stressed times.

Comments

[Larry House:]

I think it is premature to say the crisis has past. Junk bonds have runup too far and too fast just like stocks. I don't yet see very much that is "normal."

Aug 31 12:04 PM

[Robert H. H...:]

Nice article, although as I eyeball your first graph, we'd have to see the default rate start declining before concluding whether Moody's estimate of the peak default rate was too pessimistic or simply too early.

Also, I would observe that "... Total return to the High Yield Index (Merrill's Master II) is 40.0% through 8/28, well above last year's -26% debacle...." really just means that total return for the 20 months ending August is 3.6% (.76 x 1.4 = 1.036) consistent with your observations elsewhere that the high-yield vs. investment grade risk premium is hard to find.

Aug 31 12:29 PM

[djackson:]

I'd agree that it is too early to conclude the Moody's estimate is wrong. Even if it is, identifying just Moody's probably misleads in that S&P, Altman, and a number of the broker/dealers were also forecasting fairly high rates. Part of the reason defaults may be delayed may lie with banks renegotiating covenants/loan terms to stave off defaults and preserve the bank balance sheets.

Aug 31 12:44 PM

[Graham and ...:]

The rating agencies are (by definition) behind the curve. They are "too loose" early on and "too tight" in the later stages of the downcycle. But watch; they'll "pull" their negative ratings just in time for the "double dip."

Aug 31 02:04 PM

[notsosmart:]

why would anybody in view of recent history pay attention to moody & the other rating agencies?dumb& dumber i guess.

Aug 31 02:20 PM

[Gregory Orr:]

Where's the revenue growth? Can we really expect profit growth to be driven by cost-cutting, and layoffs, indefinitely? Seems like we're in a massive "extend and pretend" market, with oodles of juicy euphoria heaped on, but I don't see significant signs of revenue growth in the broad market. As global stimulus effects abate, we're basically left with inflation and default as exit strategies to the debt mountain...

Aug 31 02:30 PM

[LKofEnglish:]

actually as all too well reported by zero hedge the problem with this crisis is with the banks. now that "too big to fail" has as a direct result of government policy become "even bigger to cause even greater failure" the issue of credit quality AMONG THE BANKS still is just beginning to be realized and indeed if Moody's is making the argument that the government response has made matters worse then FINALLY they're doing shareholders a service, let alone for the first time in decade finally doing their job.

Aug 31 04:47 PM

[George Kesa...:]

Moody's estimate is wrong and has been wrong for the past 5 yeas that I follow such numbers.

They have never been right.

Aug 31 06:43 PM

[tj7654:]

George, actually their numbers have been pretty close and you can check that on their annual default report which is made available to the public for free

Sep 01 12:27 PM