Historic Default Rates And The Risk Of CDS Indices & Tranches

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Historic Default Rates and the Risk of CDS Indices & Tranchesinfo

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keyboard_arrow_downkeyboard_arrow_upDouglas J LucasDouglas J LucasDouglas J Lucas

2008, UBS CDO Research 2008

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Abstract

What can historic default rates tell us about the risk of credit default swap indices and tranches? In this CDO Insight, we calculate “fair prices,” i.e., index and tranche premiums such that the present value of premiums exactly equals the present value of expected credit event payments. We calculate different breakeven prices using default and recovery rates from three different historic periods: • an equal weighting of historical experience 1970-2007; • the worst default experience within 1970-2007, i.e., 1986-1990 for investment-grade credits and 1989-1993 for the speculative-grade credits; • the nadir of the Great Depression, 1932-1936. Default rates are input as default probabilities into a simulation model that allows for default rate volatility. Historic recoveries are input into the model to produce recovery distributions. Our analysis covers the five-year tenors of the following indices and their tranches: North American investment grade (CDX NA IG), North American high yield (CDX NA HY), and European investment grade (iTraxx).

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Key takeaways

AI generated

1. Recent premiums for CDS indices imply defaults exceeding Great Depression levels, indicating heightened risk.
2. The analysis compares breakeven premiums for credit default swaps using historical default rates from 1970-2007.
3. Investment-grade indices consistently price in higher defaults than North American high yield indices.
4. Simulations reveal zero credit event losses for the most senior tranches across various scenarios.
5. Equity tranches exhibit lower default pricing compared to senior tranches, suggesting a risk-reward trade-off.

FAQ's

AI generated

What default trends emerged in CDS indices compared to historical data?add

Recent CDS indices show that premiums on investment-grade indices surpass those implied by historical worst-case default rates, indicating potential mispricing. Specifically, for investment-grade indices, premiums frequently exceed 2.4%, the highest five-year average default rate across cohorts from 1970-2007.

How did historical recovery rates factor into default simulations?add

The simulations utilized recovery rates that varied significantly, with averages ranging from 21% in 2001 to 63% in 1995. This substantial range allows for a nuanced interpretation of default probabilities and their impact on tranche performance.

What methodological approach addressed variability in default rates?add

The research employs a dual-source methodology, capturing both time-series variability and cross-sectional variability among portfolios. This enables a more accurate simulation of default rates by considering differences in economic conditions and cohort performance over time.

When did the highest recorded CDS defaults occur and what were the rates?add

The highest five-year cumulative default rates recorded were 15.5% for investment-grade and 40.7% for speculative-grade, as seen during the Great Depression cohort from 1932-1936. These rates serve as critical benchmarks for analyzing current CDS market premiums.

What are the implications of the findings for trading strategies?add

The findings suggest that selling protection on investment-grade tranches—given their higher-than-historical premiums— could provide lucrative returns compared to high-yield tranches. Specifically, strategies that involve going long on investment-grade indices while shorting high-yield indices might prove beneficial.

Related topics

Structured FinanceCollateralized debt obligationcloseTitleAbstractKey TakeawaysFAQsSimulation MethodologyMethodological CaveatsBreakeven Premium ResultsTrading ImplicationsConclusion1 of 17format_list_bulletedOutlineAll TopicsBusiness and ManagementFinancebookmark_borderSave shareShare

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