October 23, 2008 / 3:27 PM / 11 years ago

Crossover prices indicate default rate up to 50%

LONDON, Oct 23 (Reuters) - Fresh record levels for Europe’s Crossover credit derivatives index of 50 mostly junk-rated companies are pricing in expectations that one-third to as many as one-half of them will default over the next few years.

High-yield spreads have widened dramatically this month as investor attention has shifted from the acute stress of the financial crisis to concerns about the longer-term prospects for non-financial companies.

The Markit iTraxx Crossover index ITEXO5Y=GF has hit a series of records in the past two weeks, taking it from around 566 basis points on Oct. 1 to near 820 basis points on Thursday.

At 800 basis points, the index implies a loss of 33 percent. At a zero percent recovery rate, that would mean about one-third of its companies default. At a historical average recovery rate of 40 percent, that probability of default rises to 50 percent of index companies. [ID:nLK176512]

Europe’s high-yield, non-financial companies do not face an imminent threat of running short of cash, analysts say.

“Near-term liquidity is not the problem, but for these highly leveraged businesses, the question is what’s going to happen in two or three years,” said Robert Jones, head of high-yield research at Barclays Capital.

The challenges include: a likely prolonged global economic slump that could shrink earnings and cash flows; a high-yield bond market that has already been shut for more than a year and is likely to remain closed for years to come; the bulk of debt repayments starting from 2010 and 2011; and, before then, a risk of breaching covenants — committed financial targets — at a time that lenders are less inclined to be forgiving.

“We have got to this point (to current spreads) because of a rush for the exits, and because people do not want to add risk,” said Suki Mann, head of credit strategy at SG CIB.

“It has been mostly a technical issue, but it is now merging into a fundamental one,” he added.


In another measure of stress, the number of Crossover members trading upfront have jumped to 12 from seven this week.

Upfront status indicates that the perceived risk of a jump to default is so high that most of the cost must be covered by a downpayment instead of five annual payments.

“Trading upfront historically meant that companies were in distress; it doesn’t necessarily mean that anymore,” said Chris Ucko, an analyst with independent research firm CreditSights.

“CDS pricing is showing an increased likelihood of default everywhere,” he added. “It is also showing a complete evaporation” of investor interest in taking credit risk.

Five-year CDS for Italian directories company Seat Pagine Gialle SpA PGIT.MI, for example, are now at about 28 percent upfront, according to Markit data. That means it costs 2.8 million euros upfront plus 500,000 euros per year to buy protection on 10 million euros of debt.

Upfront prices in Europe now range from 20 to 43.5 percent. Dealers usually move to quoting upfront when a company’s spreads reach 1,200 to 1,300 basis points on an annual basis. Another four Crossover members trade above 1,000 basis points.

Thursday’s 43.5 percent upfront price for petrochemical company LyondellBasell implies a default probability of around 73 percent at zero recovery and more than 90 percent at 40 percent recovery.


Even so, derivatives show a more optimistic picture than do cash bond prices.

The bond market has suffered from liquidity issues as administrators of failed banks and fund managers, facing redemptions, have been forced to sell loans and bonds. Bonds in some cases have dropped below 40 cents on the dollar.

“The bond market is pricing in Armageddon, saying that 60 percent of the universe is going to disappear,” said one high-yield bond trader. “That is not going to happen.”

The iBoxx high-yield index of euro bonds showed a spread of about 1,600 basis points over government bonds at Wednesday’s close.

That amounts to be about 1,100 basis points on an asset-swap basis, or about 300 basis points more than the Crossover on a comparable basis, said Nick Burns, a credit strategist at Deutsche Bank.

“The bond indexes are pricing in worse levels than we have historically ever seen,” he said. “The CDS market is probably a slightly better reflection of fundamentals, while the cash market clearly reflects technical issues and forced selling.”

Europe’s CDS market also reflects a less pessimistic outlook than do U.S. credit derivatives indexes.

The Markit CDX five-year index of high-yield U.S. credits was at more than 1,000 basis points. Out of its 100 members, 57 were trading upfront, led by Residential Capital at 77.75 percent and General Motors at 64.75 percent, Markit data shows. (Editing by Quentin Bryar)

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