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Market Intellect: Probability Of Default For S&P 500 Index Debt Plummets With Growing Corporate And Economic Stability

Publication date: 26-May-2010 12:08:33 EST

The Market, Credit and Risk Strategies group (MCRS) is a separate and independent research team at Standard & Poor's. The objective of this group is to provide unique financial intelligence by analyzing relationships across multiple asset classes and markets. Enabled with cutting-edge S&P and third-party applications and data, the group offers investors valuable new sources for alpha discovery and "out-of-the-box" thinking through robust data exploration and analysis. The research is delivered through the Market Intellect series that provides investors with actionable and topical market perspectives that can offer innovative ways to leverage credit and risk intelligence.

Observations

The past year has brought the simultaneous stabilization of the U.S. financial system and the commensurate rebound in financial asset prices. U.S. dollar-denominated 5-year interest rate swap spreads, which Market, Credit, and Risk Strategies (MCRS) monitors as a barometer of financial institution counterparty comfort and trust, have declined to just 27 basis points (bps) as of May 17, 2010, from 43 bps on May 18, 2009. The S&P 500 Equity Index, a proxy for investor confidence in the U.S. financial system, likewise has rallied 27% over the past year to 1,134.5 from 892.9. U.S GDP reached 3.2% in first-quarter 2010, a significant improvement from the 6.4% contraction posted in first-quarter 2009.

In addition to representing a relative indicator of how well an individual security is compensating its owner for risk, MCRS' new Risk-to-Price (R2P) score can also provide investors with valuable intelligence about the current health of corporate America and, by extension, the U.S. economy. The individual components of R2P, which include bond price and yield information and a quantitative estimate of obligor probability of default (PD), can help investors determine to what degree corporations currently benefit from economic and financial recovery.

Key Findings

  • Average PD for debt issued by nonfinancial S&P 500 companies declined 1.36 percentage points, or almost 95%.
  • Bond price historic volatility shed almost half its prior-year value.
  • Average yield-to-maturity declined by nearly 300 bps.
  • R2P scores rose more than 200%.

Research Output And Analysis

To investigate what economic and financial stability has meant for U.S. corporations over the past year, MCRS compiled R2P component intelligence for all debt with at least $50 million outstanding issued by S&P 500 constituents, excluding the financial sector. We excluded financial sector corporations to remove the influence of the extraordinarily large shocks previously experienced by Wall Street and, more importantly, the massive policy response from the federal government to shore up the U.S. financial system.

Our analysis covered more than 2,500 bonds, and the aggregated R2P component statistics show that U.S. corporations have benefitted significantly from economic and financial stability. The average estimated one-year forward-looking probability of default (PD) declined to just 0.075% as of May 17, 2010, from 1.43% on May 18, 2009. Corporate bond market price volatility (20-day standard deviation) has also improved markedly to 0.006% from 0.011% a year ago. Diminishing market and credit risks have compressed the average yield of outstanding S&P 500 debt to 4.52% today from 7.50% one year ago (see table 1).

Performance Of S&P 500 Corporate Debt
Five-year swap (bps) S&P 500 Index Average R2P score Average PD (%) Average volatility (%)
5/1/09 43 892.9 27.4 1.432 0.011
5/1/10 27 1134.5 74.1 0.075 0.006
PD--Probability of default. bps--Basis points.

Economic Causes And Effects

Rising interbank money market counterparty confidence and comfort, as highlighted by interest-rate swap spreads steadily declining since the first quarter of 2009, have benefited U.S. consumer activity and corporate earnings, which in turn have pushed equity prices higher over the course of the past year. Rising stock market capitalization likewise has contributed to the improvement in the collective credit risk profile associated with S&P 500 issues, as illustrated by the plunge in estimated PD to 0.075% from 1.432%. The past year's improvement in both economic activity and corporate credit risk has enabled the 298-bps decline in average yield-to-maturity for S&P 500 debt. Combined, these factors have produced an improvement in average R2P scores for nonfinancial S&P 500 debt, to 74.1 on May 17, 2010, from a depressed 27.4 on May 18, 2009.

Looking ahead, continued economic and financial sector recovery will eventually elicit some degree of policy normalization by the Federal Reserve. A non-negative real interest rate for Fed funds suggests that the overnight target rate, at minimum, will eventually increase to at least 2%. Past experience, particularly the Fed's prior tightening cycle between June 2004 and June 2006, suggests a normalized range of 40 bps to 55 bps for 5-year dollar interest-rate swap spreads (see chart). Once the Fed begins to remove financial crisis-motivated excess accommodation from the financial system, investors will be able to gauge the impact on U.S. corporations through changes in both R2P scores and the individual components of the R2P approach to identifying relative risk and value in corporate securities.

Underlying Data And Resources

Risk-to-Price scores, which we calculate using our proprietary data, are currently available individually on the Global Credit Portal (in beta). Swap spread history for 5-year dollar interest rates comes from Global Insight.

This report was prepared by S&P's Market, Credit and Risk Strategies group. This group is analytically and editorially independent from any other analytical group at S&P, including Standard & Poor's Ratings Services.

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Market, Credit, and Risk Strategies:Michael Thompson, Managing Director, New York (1) 212-438-3480;
michael_thompson@standardandpoors.com
Robert Keiser, Senior Director, New York (1) 212-438-3540;
robert_keiser@standardandpoors.com

No content (including ratings, credit-related analyses and data, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of S&P. The Content shall not be used for any unlawful or unauthorized purposes. S&P, its affiliates, and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an ?as is? basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT?S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with any use of the Content even if advised of the possibility of such damages.

Credit-related analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact or recommendations to purchase, hold, or sell any securities or to make any investment decisions. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P?s opinions and analyses do not address the suitability of any security. S&P does not act as a fiduciary or an investment advisor. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives.

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