Risk Management

U.S. Credit Risk Brightens as Gloom Hits Europe

Credit risk will improve in North America but heighten in Europe in the next three months, according to credit portfolio managers.
Vincent RyanJanuary 24, 2012

Loan portfolio managers at banks and insurance companies think credit risk in the United States and Europe will head in drastically different directions in the next three months. They see credit spreads and credit default rates improving in North America but worsening across the Atlantic, especially if there is a sovereign default. The trend, if it plays out, could have strong implications for companies’ cost of credit and international capital flows.

The portfolio managers from Europe, North America, and Asia were surveyed this month by the International Association of Credit Portfolio Managers (IACPM), which every quarter asks if certain credit indices will improve, worsen, or stay the same in the next three months. The survey results are calculated as a diffusion index, which shows direction and the degree of consensus.

The results, issued this week, show the credit spread outlook improving in North America this quarter, as measured by the CDX North America Investment Grade 5-year, an index of credit-default-swap spreads. On a scale of -100 to 100, with a positive number indicating spreads will narrow, the North America index reading was 19, up from 0 last quarter.

In Europe, on the other hand, managers said the spread of the iTraxx Europe 5-year, also a CDS index, would widen. That reading came in at -21.1, down from -15.4 last quarter, suggesting the view is gaining traction. Portfolio managers think the high-yield versions of these respective North American and European CDS indices will perform similarly.

“In the last survey, people were pretty much bearish across the board,” says Som-lok Leung, executive director of the IACPM. “There’s continued bearishness about Europe, but in North America there are at least glimmers of hope.”

The potential divergence of spreads across regions is the most surprising result of the survey, says Leung. “If you look at the fall of 2008, when Lehman went bankrupt, virtually all markets got worse in lockstep — correlations were very, very high,” Leung says. “When correlations are high, it’s very difficult to diversify.”

When the IACPM asked managers about a North America-Europe divergence, they said there was little interconnectedness among clients in the United States and Europe — that U.S. corporate performance created “an underlying tone of recovery.”

“The thing that could be different now from when Lehman went bankrupt is that the euro crisis has been dragging on for two years,” Leung speculates. “In that time, U.S. firms have been proactively preparing in case there is an explosion in Europe.” In contrast, European companies are finding it very hard to safeguard against these risks and minimize the impact of a possible European meltdown, he says.

Still, portfolio managers are hardly unanimous about the outlook for North American CDS spreads. The readings from the IACPM survey show there is less consensus than a year ago. Meanwhile, managers are slightly more certain than a year ago that European credit spreads will widen.

On a global basis, portfolio managers think credit default rates for corporates, consumer mortgages, and commercial real estate will worsen during the next 12 months, although their view has improved from last quarter.

“There is a lot of uncertainty in the marketplace — you can see that in North America,” says Leung. “We get information on employment that is slightly better, but no so much better that we can say with a great degree of certainty that we are out of the hole.”

The IACPM uses credit default swap indices because they are the best pure measures of credit risk, as opposed to bond indices, which account for both credit and interest-rate risks, says Leung.

Credit portfolio managers are involved in hedging or securitizing loans, as well as originating the assets. Since they use credit default swaps to reduce risk, they usually have definite views about the direction of credit, Leung says.