Rising Fears of Corporate Defaults

The price of insuring even the safest corporate debt against default has shot up, on demand from big investors who fear serious housing and credit-related trouble

by Steve Rosenbush

Big investors are increasingly concerned about the prospect of widespread defaults among U.S. companies with currently sound credit ratings. One glaring piece of evidence? The price of insuring corporate debt against default has soared, according to a new report from analysts at Walnut Creek (Calif.)-based Credit Derivatives Research.

The price of default insurance on a key composite of investment-grade corporate bonds soared 20% this week, according to Tim Backshall, chief credit derivatives strategist at Credit Derivatives. As of Oct. 25, it would cost $600,000 a year to insure a $100 million investment in the CDX, an index of 125 corporate bond issues including such companies as General Electric (GE), builder Toll Brothers (TOL), and Radian Group (RDN), which provides credit protection to mortgage lenders and others. Last week, such insurance would have cost $500,000. In January, the cost was $350,000.

Even more worrisome, the price of insurance on the supposedly safest "super senior" class of CDX debt is rising, too. That "super senior" class, or tranche, means the buyer of the insurance is protected unless more than 30 of the 125 components of the CDX default over a certain period. The price of such insurance on the "super senior" tranche is now $140,000 a year, up 55% in just the past week, fueled by heavy demand.

It's the change in the price of insurance on the "super senior" debt that caught the attention of Credit Derivatives. "There's a rising risk of more widespread defaults on corporate debt, as opposed to a few idiosyncratic defaults," says Byron Douglass, a senior Credit Derivatives research analyst and author of the report. "They could be more contiguous over the next few years."

Merrill Adds to Concerns

Demand for corporate default insurance is rising. The surging cost reflects the sentiment of big investors such as pension funds and hedge funds, which can trade in such insurance contracts even if they don't hold the underlying debt tied to the insurance policy. Such investors use the insurance policies to bet that the number of defaults will rise as the credit crunch and the slowing housing market exact a toll on the economy, pushing a greater number of companies into default. They don't even need to bet on which specific companies will default, since the insurance is tied to the index, overseen by Dow Jones (DJ).

Comments by Merrill Lynch (MER) Chief Executive Stanley O'Neal on Oct. 24 may have stoked the general fears (BusinessWeek, 10/24/07). He said Merrill, which reported an $8 billion write-down that same day, sold off lower-rated assets during the first quarter as the credit crunch began. It held on to higher-rated tranches of debt, and hedged against their possible decline in value. "We hedged…but not aggressively or fast enough," O'Neal said. The fact that Merrill's huge write-down was tied to higher-rated tranches of debt may have scared investors.

The concern is driven by several forces, according to Credit Derivatives. There's a fear that troubles in the housing market will depress consumer spending. There's also rising nervousness that huge, credit-related write-downs in the banking sector could force a major financial institution to go under, according to Backshall. Citigroup (C) reported a $6 billion write-down (BusinessWeek, 10/15/07) earlier in October. Merrill Lynch reported $8 billion in write-downs on Oct. 24. The worry is that a combination of housing and credit-related problems will cause systemic trouble in the financial system and the economy, leading to widespread defaults.

Low Default Rate, For Now

Such jitters abound in the market. On Oct. 25, shares of insurance and banking giant American International Group (AIG) dipped more than 6% at one point, after a Citi Investment Research analyst estimated that AIG could face losses as high as $1.6 billion from its exposure to subprime markets. The financial-services conglomerate said those fears were unfounded, but its shares finished 3.2% lower at $61.79, after setting a new 52-week low during the session.

The default rate on corporate debt has been just over 1% (BusinessWeek, 11/10/06) for some time. That's well below average, which is in the 4% range. No one expects the rate to remain so low forever. But the assumption has been that defaults would rise mostly in the speculative, or junk, part of the market. The fear that widespread defaults could occur among well-established companies with investment-grade credit ratings is new.

The systemic risk is that investors will be forced to sell off higher-rated assets to cover bad bets on assets with lower ratings—indeed, in its bombshell news this week, Merrill Lynch warned it could not guarantee against such a risk. In such a climate, default insurance has become the hot new buy among large investors.

Rosenbush is a senior writer for BusinessWeek.com in New York.