A week ago, the reputation of legacy carrier American Airlines as being the only one to avoid bankruptcy is not the only thing that went pop. Along with it went the fervent optimism of high yield debt investors that moral hazard spreads not only to insolvent countries and insolvent banks, but to all insolvent corporates. On Wall Street, there is actually a technical name for perspective on insolvency optimism when viewed through the prism of CDS, where it is known as "Jump Risk", or the likelihood of a company to file tomorrow as opposed to a year from now. Until AMR, jump risk was not an issue. Now, it has come back with a vengeance. As Bloomberg LevFin magazine reports, "AMR’s bankruptcy is taking the corporate debt market by surprise, with investors losing 25 percent on bets in junk-bond derivatives that there wouldn’t be a jump in defaults this year. The Chapter 11 filing from the parent of American Airlines is helping to fuel a plunge in the value of credit-default swaps that take outsized losses when companies in a benchmark index fail. The contracts, which back the debt of borrowers including ResCap and Radian, plunged to 64 percent of face value as of yesterday from 85 percent on Nov. 8. The derivatives were three weeks away from expiring with gains on Nov. 29, when AMR filed for protection." Oops. Alas, that's what happens every time unfounded optimism gets away from reality, especially when one is dealing with "junk", literally, which as the name implies is one TBTF if it is 99% unionized.
Bloomberg has more:
The failures of AMR, and those of Dynegy and PMI, are driving investors to recalibrate their expectations for when borrowers may miss debt payments as companies that aren’t considered immediate candidates abruptly fail. That’s a scenario known among debt traders as jump-to-default risk.
“People are really worried about jump risk,” said Mikhail Foux, a Citi structured credit strategist. “If you asked people in June, July, or even August,” he said, most “said defaults at some point were going to pick up, but that it was unlikely to be soon.” Even after accounting for AMR’s failure, swaps that protect against further defaults before Dec. 20 in the benchmark Markit CDX North America High Yield index, Series 11, were trading last week at 10 percentage points below face value, according to Citi. Investors were using index tranches to earn yields that in April were more than twice those of typical high-yield bonds, which were about 7 percent.
Is AMR the last one? Hell no:
The upfront cost of CDS on Radian for the next year surged 49 percent since Sept. 30, compared with a 21 percent increase on five-year contracts, according to CMA. One-year swaps on ResCap surged 187 percent and five-year contracts jumped 140 percent on speculation Ally will place its unit into bankruptcy.
Alas, the market buy first, and asks questions never, as has always been the case:
The global default rate for speculative grade debt rose in October after five months of easing, with the 12-month trailing rate increasing to 1.68 percent from 1.65 percent in September, S&P said. In April, when speculative-grade yields were at about record lows and Moody’s predicted the global default rate among junk-rated issuers would drop to 1.5 percent by year-end, investors were paying more than 88 percent of face value for the lowest-ranked high-yield index tranche, a price that would have returned an annualized 17 percent had none of the companies in the benchmark defaulted.
And while the discrepancy between reality and optimism always leads to casualties, a far bigger issue is the upcoming roll cliff in not only sovereign and financial debt, but in bank debt as well. Which in 2012 and 2013 will be a rude wake up call to many companies which may do the AMR thing and simply opt the Chapter way out:
Speculative-grade bank debt maturing in 2012-2013 may triple to almost $100 billion from $32 billion, leading to an “unexpected” surge in leveraged-loan issuance, according to Moody’s. The rise will be driven by companies accelerating the refinancing of 65 percent, or almost $39 billion, of the total junk-rated bank credit maturing in 2014, Moody’s analysts led by Tiina Siilaberg said yesterday in a report. “Most maturities are pulled forward by one year,” Siilaberg wrote. “In 2013, we expect approximately $30 billion to be pulled forward from 2014.”
The party in high beta fixed income is about to end.