The Kamakura Troubled Company Index, a barometer of corporate credit risk, rose for the fifth straight month at the end of September, indicating that a greater number of companies globally are at risk of defaulting on their debts.
The troubled company index rose 50 basis points to 9.73%. It hit a record low of 4.36% in December 2010, but has since been climbing. During the financial crisis, in November 2008, the Kamakura index hit a seven-year high of 25.57%.
“Early in the year and through the early summer, there was a pretty low default probability, and then at the end of the summer default probability rose consistently and continued to do so the last couple of months,” says Martin Zorn, chief administrative officer of Kamakura Corp., a provider of risk information services and tools. “There has been a deterioration in credit quality among the [30,000 global, publicly held] companies in the index. We see an increase in risk.”
The Kamakura index takes into account macroeconomic and company-specific factors. For example, low interest rates push down default probability, but high unemployment increases default probability. Share prices also factor into the formula.
Since the Kamakura index is global, economic turmoil overseas has contributed to the recent rise. “The earthquake in Japan sent some of the default probabilities for Japanese companies up significantly,” says Zorn. “And what’s happening in Europe is translating into very high default probabilities for the European banks, because of their exposure to sovereign credit risk.”
In North America, some of the problems are industry specific. The fairly consistent increase in default risk is among (1) companies exposed to residential construction and housing, like homebuilders, mortgage companies, and insurance providers; and (2) transportation-related businesses, which have been hit by high oil prices and the slowdown in inventory builds. “The rest of the North America story is company specific,” Zorn says.
Entering the fourth quarter, the Kamakura index has fallen slightly, but Zorn says that’s due in part to third-quarter earnings reports filed so far. “The historically stronger [corporate] performers file earlier,” says Zorn, and because the index is not value weighted, big profits from large companies can temporarily lower the index.
The index measures the percentage of companies that have more than a 1% risk (annualized) of defaulting in the next 30 days. While 1% sounds low, problems can mount quickly, says Zorn.
Indeed, companies at 1.5% default risk are “the ones that will get you,” he says, “because the risk is right below the surface of the water and can escalate quickly if you’re not paying attention.” Eastman Kodak, for example, “was bumping along fairly low, and then all of a sudden it jumped up right away.” In contrast, by the time a company hits a 20% probability of defaulting, “everyone in the market knows the risk is there, because the tip of the iceberg is showing,” says Zorn.
In September the companies with the five largest increases in 30-day default risk were Kodak, Spanish Broadcasting System, General Maritime, Headwaters, and AMR Corp. Tokyo Electric Power Company continues to be the firm with the world’s highest one-month default risk among rated companies, with a default probability of 61.27%.