April 2021 ADVOCATE CAPITAL MANAGEMENT, LLC
Special Topic: A Real-Time Credit Risk Monitor (Some Assembly Required)
Can you feel it in the air? (There's danger in the air) Danger (such a strange emotion) Can you feel it in the air? - Billy’s Got a Gun by Def Leppard
Investors and corporate treasurers periodically wish for a real-time credit risk monitor, especially during times of crisis. The recent news of a large family office defaulting on its equity swap positions and leaving many banks scrambling to unwind their hedges clearly illustrates the benefits of such a timely credit gauge. While the rating agencies did put the credit ratings of some banks in question on negative watch, investors often wish they could visualize how much the market is penalizing these companies in real time.
In this article, Advocate presents a framework for assessing real-time market perception of the credit quality of financial and non-financial corporations. This tool would be helpful to any corporate Treasurer or investor who need a live monitor of the evolving market perception of the credit quality of their counterparties and/or investments. The analysis consists of the following steps: 1) Rating agencies’ perception of credit risk 2) Broad market perception of credit risk and spread 3) Market perception of individual entities’ risk 4) A means of combining and comparing the above A brief caveat: our goal is not to calculate where the rating agencies should rate the credit, but rather where the market-implied credit rating would be in the context of the broader bond market. The difference between a market-implied rating and an agency rating is due to the sum of two factors: the specific entity’s credit risk and the deviation of the specific sector’s credit spread from the broad market. As such, there is as much information contained in the implied ratings change over the past month as the implied ratings themselves.
1. Rating Agencies
If rating agencies assign ratings on a real-time basis, there would be no need for this article. But as we know, rating agencies’ credit ratings changes on the order of months, quarters and years rather than days or weeks. This renders rating agencies’ credit assessment ineffective during times of crises when information can be obsolete in a matter of hours.
Nevertheless, the starting point of our analysis is to pinpoint the rating agencies’ perception of counterparty risk is. We provide in the following table a listing of some of the largest global counterparty banks and the latest credit ratings of the senior-most entities (usually the bank or the derivative counterparty entities).
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FIGURE 1. 3 MAJOR RATING AGENCY CREDIT RATING OF SENIOR-UNSECURED CREDITS OF VARIOUS GLOBAL BANKS Moodys S&P Fitch Avg of Rating Counterparty Ratings Outlook Ratings Outlook Ratings Outlook Agency Ratings Toronto Dominion Aa1 STABLE AA- STABLE AA NEG AA Royal Bank of Canada Aa2 STABLE AA- STABLE AA+ NEG AA JPMorgan Aa1 STABLE A+ STABLE AA NEG AA CIBC Aa2 STABLE A+ STABLE AA+ NEG AA Wells Fargo Aa1 NEG A+ STABLE AA- NEG AA- Scotiabank Aa2 STABLE A+ STABLE AA NEG AA- Bank of Montreal Aa2 STABLE A+ STABLE AA NEG AA- UBS Aa2 STABLE A+ STABLE AA- STABLE AA- Bank of America Aa2 STABLE A+ STABLE AA- STABLE AA- ING Bank Aa3 STABLE A+ STABLE AA- NEG AA- Morgan Stanley Aa3 STABLE A+ STABLE AA- STABLE AA- Rabobank Aa3 STABLE A+ NEG AA- NEG AA- BNP Aa3 STABLE A+ NEG AA- NEG AA- Credit Agricole Aa3 STABLE A+ NEG AA- NEG AA- HSBC A1 STABLE A+ STABLE AA- NEG A+ Citi Aa3 STABLE A+ STABLE A+ NEG A+ BNY Melon A1 STABLE A STABLE AA- STABLE A+ Natixis A1 STABLE A+ NEG A+ NEG A+ Goldman Sachs A1 STABLE A+ STABLE A+ NEG A+ Credit Suisse Intl Aa3 NEG A+ NEG A NEG A+ Barclays A1 STABLE A STABLE A+ NEG A+ SMBC A1 STABLE A STABLE A NEG A Societe Generale A1 STABLE A NEG A- STABLE A MUFG A1 STABLE A STABLE A- STABLE A Mizuho A1 STABLE A STABLE A- STABLE A Banco Santander A2 STABLE A NEG A- NEG A Commerzbank A1 STABLE BBB+ NEG WD A- Banco Bilbao A3 STABLE A- NEG BBB+ STABLE A- Unicredit Bank AG A2 NEG BBB+ NEG BBB NEG BBB+ Deutsche Bank AG STABLE POS POS A3 BBB+ BBB+ BBB+ Table lists top-tier ratings at the bank subsidiary level. Sources: Moody’s, Standard & Poor, Fitch, Bloomberg, Advocate
This is not meant to be an exhaustive list and we do apologize if we missed some of your favorite banks/counterparties in this article. Please reach out to Advocate if you would like to discuss any specific banks / counterparties not included on this list.
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We assign a numerical score to each credit rating.
FIGURE 2. RATINGS SCORE Moodys S&P Fitch Score Aaa AAA AAA 1 Aa1 AA+ AA+ 2 Aa2 AA AA 3 Aa3 AA- AA- 4 A1 A+ A+ 5 A2 A A 6 A3 A- A- 7 Baa1 BBB+ BBB+ 8 Baa2 BBB BBB 9 Baa3 BBB- BBB- 10 Ba1 BB+ BB+ 11 Ba2 BB BB 12 Ba3 BB- BB- 13 B1 B+ B+ 14 B2 B B 15 B3 B- B- 16 Caa1 CCC CCC 17
D D D 18 Source: Advocate
For example, JPM’s rating (Aa1/A+/AA) maps to 2/5/3 for an average of 3.33, which is rounded to 3, or an average rating of AA.
2. Broad Market Perception of Risk
Phase 2 is to assess and quantify the current market perception of risk by credit rating. To do that, we will make use of Bloomberg Barclays’ aggregate bond indices. We will use U.S. bond indices as the U.S. bond market is by far the most liquid and transparent in the world. To capture the credit risk of the broad bond market, we will use an intermediate-term and a longer-term set of indices.
The short-term bond indices are:
1. AAA: Bloomberg Barclays US Corporate Aaa 3-5yrs 2. AA: Bloomberg Barclays US Corporate Aa 3-5yrs 3. A: Bloomberg Barclays US Corporate A 3-5yrs
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4. BBB: Bloomberg Barclays US Corporate Baa 3-5yrs 5. High Yield: Bloomberg Barclays US High Yield Corporate 3-5yr
The intermediate-term bond indices are:
1. AA-to-AAA: Bloomberg Barclays US Corporate 5-10yrs AAA/AA 2. A: Bloomberg Barclays US Corporate 5-10yr A 3. BBB: Bloomberg Barclays US Corporate Baa 5-10yrs 4. High Yield: Bloomberg Barclays US High Yield Corporate 7-10yrs
The durations of the short-term bond indices range from 2.1 to 4.0, while the intermediate-term bond index durations range from 5.7 to 6.6. The option-adjusted spread (OAS) to swaps of the two sets of indices is shown in the next figure. In general, longer-maturity index OASs should be higher than shorter-maturity index spreads, i.e. the spread for similar credits should be higher as maturities lengthen.
FIGURE 3. SHORT AND INTERMEDIATE-MATURITY INDEX OAS TO SWAPS
Data as of April 8, 2021. Sources: Bloomberg, Barclays, Advocate
This chart reflects where markets are currently pricing in a broad perception of risk for a particular credit rating.
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3. Market Perception of Credit Risk - Credit Default Swap and Bond Spread
After quantifying the market assessment of credit risk, the third phase of the analysis is to quantify an individual company’s market-perceived credit risk. To do that, we can either use the credit default swap (CDS) market or the option-adjusted spreads (OASs) of a company’s outstanding bonds.
CDS is used by hedgers and speculators to trade on the credit-worthiness of a company. Typical CDS tenors run for 1-to-5 years. In return for a protection-buyer paying a fixed premium for a fixed tenor, the hedger would be able to exchange any bonds that are eligible securities for par. The market mechanism is usually an auction held a month after an ISDA declaration of an event-of-default (EOD) in which a bond auction takes place. The settlement amount of the CDS contract would be the difference between par and the auction price. A sale of 5yr CDS plus a cash investment should be risk- neutral versus a 5yr bond of the same issuer, therefore we treat CDS and bond OAS-to-swaps as basically the same. In order to compare spreads to the US bond market indices, we convert non-USD denominated CDS to an USD-equivalent CDS using the cross-currency basis swap spread.
For issuers that are not traded in the CDS market, we would alternatively use the credit spread of intermediate maturity senior unsecured bond. The OAS-to-swap of a 5-year bond should be approximately analogous to a 5-year CDS on the issuer. In Advocate’s analysis, we opt to use CDS for large and frequent bond issuers and bond OAS for infrequent issuers which may not have a traded CDS. For the largest global banks, their average credit ratings versus 5-year CDS are shown in the chart below.
FIGURE 4. BANK AVERAGE AGENCY CREDIT RATINGS (X-AXIS) VERSUS 5-YEAR CREDIT DEFAULT SWAP SPREAD LEVELS (Y- AXIS)
Data as of April 8, 2021. Sources: Bloomberg, Moody’s, Standard & Poors, Fitch, Advocate
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We can draw some simple perspectives from the chart:
1. There is a correspondence between credit rating and perceived market risk – lower rated banks (right-hand side of the chart) tend to command higher CDS (higher part of the chart). However, two banks with similar CDS can have very different average rating. For example, Commerzbank and JPMorgan CDS trade at similar levels of 48 and 45bps respectively, but Commerzbank has an average agency credit rating of between BBB-plus and A-minus, while JPMorgan’s average agency credit rating is between A+ and Aa1. 2. There can be a significant difference in the market perception of risk for two banks that may be rated similarly by the rating agencies. For example, ING Bank and Morgan Stanley both have average ratings between A+ and AA-. But their credit default swaps tell a very different story, with MS CDS trading over 50bps while ING CDS is at 24bps.
4. Comparing Agency to Market-Implied Ratings.
What are the ratings implied by market-transacted credit spreads (CDS or bonds), and how do they compare to the average rating agency credit ratings? We can calculate market credit spread-implied ratings by mapping individual credit spreads to the broad bond market index spreads from Part 2 of the analysis and adjust for the 5yr maturity of the market spread by interpolating between the short- and intermediate-term indexes. This produces a market-implied credit rating that we can then compare to agency ratings and is shown below:
FIGURE 5. MARKET-IMPLIED RATINGS (Y-AXIS) VERSUS AVERAGE RATING AGENCY RATINGS (X-AXIS) OF SENIOR- UNSECURED CREDITS FOR VARIOUS BANKS
Data as of April 8, 2021. Sources: Moody’s, S&P, Fitch, Advocate, Bloomberg.
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The comparison can be viewed in tabular form as well.
FIGURE 6. MAJOR RATING AGENCY CREDIT RATING VS MARKET-IMPLIED RATINGS OF SENIOR-UNSECURED CREDITS OF VARIOUS GLOBAL BANKS Moodys S&P Fitch Avg of Rating CDS Implied Counterparty Ratings Outlook Ratings Outlook Ratings Outlook Agency Ratings 5y CDS Ratings Toronto Dominion Aa1 STABLE AA- STABLE AA NEG AA 36 A+ Royal Bank of Canada Aa2 STABLE AA- STABLE AA+ NEG AA 53 A JPMorgan Aa1 STABLE A+ STABLE AA NEG AA 45 A CIBC Aa2 STABLE A+ STABLE AA+ NEG AA 47 A Wells Fargo Aa1 NEG A+ STABLE AA- NEG AA- 59 A- Scotiabank Aa2 STABLE A+ STABLE AA NEG AA- 54 A- Bank of Montreal Aa2 STABLE A+ STABLE AA NEG AA- 66 BBB+ UBS Aa2 STABLE A+ STABLE AA- STABLE AA- 32 A+ Bank of America Aa2 STABLE A+ STABLE AA- STABLE AA- 47 A ING Bank Aa3 STABLE A+ STABLE AA- NEG AA- 24 A+ Morgan Stanley Aa3 STABLE A+ STABLE AA- STABLE AA- 56 A- Rabobank Aa3 STABLE A+ NEG AA- NEG AA- 22 AA- BNP Aa3 STABLE A+ NEG AA- NEG AA- 35 A Credit Agricole Aa3 STABLE A+ NEG AA- NEG AA- 30 A+ HSBC A1 STABLE A+ STABLE AA- NEG A+ 32 A+ Citi Aa3 STABLE A+ STABLE A+ NEG A+ 53 A- BNY Melon A1 STABLE A STABLE AA- STABLE A+ 43 A+ Natixis A1 STABLE A+ NEG A+ NEG A+ 38 A Goldman Sachs A1 STABLE A+ STABLE A+ NEG A+ 59 A- Credit Suisse Intl Aa3 NEG A+ NEG A NEG A+ 65 BBB+ Barclays A1 STABLE A STABLE A+ NEG A+ 48 A- SMBC A1 STABLE A STABLE A NEG A 28 AA- Societe Generale A1 STABLE A NEG A- STABLE A 34 A MUFG A1 STABLE A STABLE A- STABLE A 30 AA- Mizuho A1 STABLE A STABLE A- STABLE A 28 AA- Banco Santander A2 STABLE A NEG A- NEG A 34 A Commerzbank A1 STABLE BBB+ NEG WD A- 48 A- Banco Bilbao A3 STABLE A- NEG BBB+ STABLE A- 38 A Unicredit Bank AG A2 NEG BBB+ NEG BBB NEG BBB+ 67 BBB+
Deutsche Bank AG A3 STABLE BBB+ POS BBB+ POS BBB+ 52 A- Data as of April 8, 2021. Sources: Moody’s, Standard & Poor, Fitch, Bloomberg, Advocate
Some simple observations can be drawn from the above chart and table:
1. European banks’ market-implied credit ratings are generally very similar to (within a 1-notch rating) agency ratings; 2. American and Canadian banks are rated higher by agencies (by more than a 1-notch rating difference) than market-implied ratings; 3. The big-3 Japanese banks’ market-implied credit ratings are generally higher (by more than a 1-notch rating difference) than agency ratings
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The observations reflect realistic market views. Japanese banks are regarded by the market as significantly more credit-worthy than their agency ratings which are capped by the Japanese government sovereign ratings of A1/A+/A. European banks are regarded as less risky than comparably-rated American banks as the market may view European governments as more likely to provide credit backstops (or at least force mergers) in case of problems. Canadian banks are generally viewed by the market as riskier than comparably-rated American counterparts as the Canadian government may be less inclined to backstop major banks.
As we indicated earlier, market-implied ratings change can be just as instructive as the implied ratings themselves. We show the one-month change in CDS levels of each bank and the prior-month CDS- implied credit ratings.
FIGURE 7. 3 MAJOR RATING AGENCY CREDIT RATING VS MARKET-IMPLIED RATINGS OF SENIOR-UNSECURED CREDITS OF VARIOUS GLOBAL BANKS AND CHANGE IN MARKET-IMPLIED RATINGS OVER THE LAST MONTH Moodys S&P Fitch Avg of Rating CDS Implied Change in Last Month CDS- 1m CDS Implied Counterparty Ratings Outlook Ratings Outlook Ratings Outlook Agency Ratings 5y CDS Ratings CDS past month Implied Ratings Ratings Direction Toronto Dominion Aa1 STABLE AA- STABLE AA NEG AA 36 A+ 0 A+ NEGATIVE Royal Bank of Canada Aa2 STABLE AA- STABLE AA+ NEG AA 53 A (2) A- POSITIVE JPMorgan Aa1 STABLE A+ STABLE AA NEG AA 45 A (1) A+ NEGATIVE CIBC Aa2 STABLE A+ STABLE AA+ NEG AA 47 A 4 A+ NEGATIVE Wells Fargo Aa1 NEG A+ STABLE AA- NEG AA- 59 A- 1 A- NEGATIVE Scotiabank Aa2 STABLE A+ STABLE AA NEG AA- 54 A- 4 A NEGATIVE Bank of Montreal Aa2 STABLE A+ STABLE AA NEG AA- 66 BBB+ (4) BBB+ POSITIVE UBS Aa2 STABLE A+ STABLE AA- STABLE AA- 32 A+ 3 A+ NEGATIVE Bank of America Aa2 STABLE A+ STABLE AA- STABLE AA- 47 A (0) A NEGATIVE ING Bank Aa3 STABLE A+ STABLE AA- NEG AA- 24 A+ 2 AA- NEGATIVE Morgan Stanley Aa3 STABLE A+ STABLE AA- STABLE AA- 57 A- 4 A NEGATIVE Rabobank Aa3 STABLE A+ NEG AA- NEG AA- 22 AA- 2 AA- NEGATIVE BNP Aa3 STABLE A+ NEG AA- NEG AA- 35 A 6 A+ NEGATIVE Credit Agricole Aa3 STABLE A+ NEG AA- NEG AA- 30 A+ 4 A+ NEGATIVE HSBC A1 STABLE A+ STABLE AA- NEG A+ 32 A+ 2 A+ NEGATIVE Citi Aa3 STABLE A+ STABLE A+ NEG A+ 53 A- 1 A NEGATIVE BNY Melon A1 STABLE A STABLE AA- STABLE A+ 43 A+ 8 A+ NEGATIVE Natixis A1 STABLE A+ NEG A+ NEG A+ 38 A 7 A+ NEGATIVE Goldman Sachs A1 STABLE A+ STABLE A+ NEG A+ 59 A- (1) A- NEGATIVE Credit Suisse Intl Aa3 NEG A+ NEG A NEG A+ 65 BBB+ 18 A- NEGATIVE Barclays A1 STABLE A STABLE A+ NEG A+ 48 A- 2 A- NEGATIVE SMBC A1 STABLE A STABLE A NEG A 28 AA- 4 AA NEGATIVE Societe Generale A1 STABLE A NEG A- STABLE A 34 A 5 A+ NEGATIVE MUFG A1 STABLE A STABLE A- STABLE A 30 AA- (3) AA- POSITIVE Mizuho A1 STABLE A STABLE A- STABLE A 28 AA- 1 AA NEGATIVE Banco Santander A2 STABLE A NEG A- NEG A 34 A (3) A POSITIVE Commerzbank A1 STABLE BBB+ NEG WD A- 48 A- 4 A NEGATIVE Banco Bilbao A3 STABLE A- NEG BBB+ STABLE A- 38 A (1) A NEGATIVE Unicredit Bank AG A2 NEG BBB+ NEG BBB NEG BBB+ 67 BBB+ (1) BBB+ NEGATIVE Deutsche Bank AG A3 STABLE BBB+ POS BBB+ POS BBB+ 52 A- 2 A- NEGATIVE Data as of April 8, 2021. Sources: Moody’s, Standard & Poor, Fitch, Bloomberg, Advocate
For example, Credit Suisse’s 5yr CDS is 65bps at the time of our analysis after widening 18bps over the past month. As a result, its market-implied credit rating dropped from A-minus to BBB+ over the same period, a 1-notch market-implied downgrade. Over the same period, the rating agencies’ actions have been limited to putting the bank’s credit on credit-watch negative.
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We note that a widening credit spread or CDS does not automatically indicate a worsening market- implied credit picture. Any credit spread widening must be considered in the context of the behavior of broad bond market index credit spreads over the same period. There would only a market-implied credit implication if an entity’s spread widens or tightens beyond that of broad-market index spreads for a comparable rating sector.
Final Thoughts – A Real-Time Credit Monitor Can Be Quite Useful During Times of Stress
A periodic market disruption can serve as a good stress test of one’s risk management framework. Having a real-time credit monitor can help treasurers and investors gauge their risk exposures and make timely risk management decisions. Advocate’s simple framework provides some insight into an entity’s credit spread change in the context of the broad bond market and can help generate valuable real-time perspectives in the midst of a rapidly evolving situation.
Advocate is working with end-users on managing LIBOR transition, rising rate, currency, credit and macro risk issues. We would be happy to discuss these and other risk mitigation issues and solutions with you.
Scott Peng Chief Investment Officer Advocate Capital Management
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DISCLAIMER
This report reflects Advocate market views and opinions and does not constitute investment advice or research.
Nothing in this report constitutes investment advice, nor does any mention of a particular financial instrument, index or interest rate constitute a recommendation appropriate to the circumstances and needs of an investor to buy, sell, or hold any financial instrument, security, or investment discussed therein. Furthermore, this report does not constitute an offer to sell or issue investment interests or securities of any kind in a commodity pool, investment fund or any other type of advised account. Such advice or offer can only be made by delivery of an offering memorandum or a CTA Disclosure Document that has been filed with and accepted by the National Futures Association (NFA). Any such offer will be subject to the terms and conditions contained in such documents, including the qualifications necessary to become an investor.
The Manager may hold or control funds which hold long or short positions in, or otherwise be interested in the financial instruments mentioned in this report.
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