Signs of Abating Default Risk
The last recession has been so severe that firms have clearly faced a higher risk of defaulting on their liabilities. When firms face a high probability of default, they tend to underinvest, a distortion known as “debt overhang.” This in turn reinforces the direct negative effects of the initial shock that caused the recession. Likewise, the recession, with its exceptionally high unemployment rate, increased some homeowners’ risk of default on their mortgages. Recent improvements in economic conditions may be having a positive effect on the risk of default in the economy, both for corporations and homeowners, and we check a few measures of risk to see if this is the case.
Credit spreads are the primary indicators of borrowers’ risk of default. The spreads that contain information on corporate default risk are those between corporate bond yields and Treasury rates. After deteriorating sharply during the second half of 2007 and during 2008, these spreads have markedly declined in 2009 and are now at levels that, although still elevated, are close to their historical means. The current level of the spread between the yields of Baa-rated corporate bonds and 10-year constant maturity Treasury notes is about 2.7 percent, only half a percentage point higher than its post-1990 historical mean. The recent improvement in these spreads points to a decrease in the market-assessed corporate risk of default.
Credit default swaps (CDS) provide further information about corporations’ credit risk. The five-year CDX North America Investment Grade Index tracks the average cost of buying CDS protection against the default of any of the underlying 125 North American investment-grade companies. If the five-year index is 100, a market participant can buy five-year protection on all of the 125 companies by paying annually 100 basis points, or $10,000 per $1 million worth of protection, per company. When the index increases, the perceived risk of those companies defaulting is increasing. The index sharply increased during 2008 but then declined during 2009 and is now less than 100: It costs less than 100 basis points per company to buy protection against default. The High Volatility Index, which tracks the subset of 30 companies with the widest CDS spreads, displayed the same qualitative behavior. The trends in both indexes indicate that the cost of buying insurance against default has decreased, and likely so has the risk of default.
We turn next to the risk that households will default on their mortgages. Again, credit spreads are an excellent source of information on this risk, but for households these spreads are between mortgage rates and Treasury rates. After increasing during the second half of 2007 and in 2008, the spread between the 30-year mortgage rate and the 10-year Treasury yield has sharply declined during 2009 and is now at levels last seen during the 1990s. Although such a large decline may be partly due to the Federal Reserve’s purchase program of federal agency debt and mortgage-backed securities, it also indicates a decrease in the market-assessed risk of mortgage default.
We conclude by observing that, in the period after 1990, measures of the risk of default have been negatively correlated with investment growth: The correlations of the AAA and Baa spreads with the growth rate of nonresidential fixed investment have been, respectively, −0.55 and −0.70; the correlation of the mortgage rate spread with the growth rate of residential fixed investment has been −0.38. There are several reasons behind these negative correlations. A decrease in investment decreases future profitability and increases the risk of default; an increase in the risk of default discourages investment because of a debt-overhang distortion; and economy-wide adverse shocks simultaneously decrease investment and increase the risk of default. In any case, these negative correlations suggest that the recent improvement in these risk-of-default indicators is likely to be associated with a strengthening of investment activity.