Assessing the risk of default

Every investment has a probability of default — it has quantitative and qualitative components. If you are buying a bond your first concern is usually quantitative, “Can this company or Government afford to repay me?”

In the case of a company — is it cash flow positive, is it solvent, what are the other and upcoming debt obligations, what is the financial and strategic position of the company? In the case of a government — how large are their deficits, how are the deficits being financed, what is happening to macroeconomic policy? Among a myriad of many other questions.

In reality, the probability of default is also affected by a wide range of macroeconomic factors that the company does not necessarily control. In the case of a government, market conditions in the global market also affect its probability of default, even though it may not have direct control over these conditions. Default risk is also affected by political factors that are harder for investors to assess than financial metrics.

MARKET RISK

The liquidity conditions in the market play a significant role in determining whether a company would have to restructure or refinance its maturing debt. Take a look at what happened to cruise companies and airlines during the depths of the novel coronavirus pandemic. An exogenous event caused the revenue and cash flow of these companies to dry up. How would they fund their operations and keep paying debt?

They went to the market to borrow even more money (albeit at a hefty price). Royal Caribbean paid 11.5 per cent to raise bonds in May 2020; Delta Airlines paid seven per cent in April 2020. Without the “easy monetary policy’’ of the Federal Reserve, these companies may not have been able to raise the funding they needed to get them through these tough times. Thankfully, markets were liquid enough (partially due to the Fed intervention) to fund these bond issuances and help the companies stay afloat. Just one year later, Royal Caribbean was able to raise new bonds at a much lower interest rate: 5.25 per cent and Delta’s seven per cent 2025 bond was trading at a yield of 2.1 per cent in mid-2021. A sign that the market conditions had eased.

Government’s create political risk and have full control of their decisions; however, it is more complex for investors to assess. Political risk is particularly relevant for sovereign bonds. We have seen instances where governments may sometimes prefer to default on bonds in order to avoid implementing the full extent of locally unpopular economic policies that would help them financially. Such policies could include raising taxes, laying off public sector workers, letting currencies find their true equilibrium, etc. Whether or not a government is capable of implementing the economic policies that are required to right past fiscal mismanagement or create a more sustainable economic future, is sometimes only revealed at the point of a crisis or during a change in administration. Political risk also applies to corporates. Just look at what has been happening in China for the past few years. When the Trump Administration initially imposed tariffs on goods from China, the stocks of many US tech companies or companies that rely on their inputs took a big dive. More recently, as the Chinese Government has increased State intervention and regulation in its economy, we have seen sizeable declines in the Chinese stock market indices. This does not imply default, but it increases the risk associated with the investment.

The road to default is not linear and the milestones along the way are affected by external factors and decisions made by the issuer along the way.

Marian ross is vice President, Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. visit our website at www.sterling. com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net. jm