Bitesize: Premium Delirium

Harry Goodacre and Nicholas Vause

Earlier this year, a number of financial market participants, commentators and regulators suggested that investors have been accepting less compensation for bearing given amounts of credit risk. This short post presents two charts in support of that view.

Both charts compare the premiums for insuring against default losses on corporate debt, as reflected in the pricing of credit default swaps (CDS), with model-based estimates or indicators of default probabilities. They make this comparison over a common set of around 70 large North American non-financial investment-grade firms. These firms have comparatively liquid CDS, which therefore give a relatively clear reflection of market pricing of credit risk.

Chart 1 compares CDS premiums with default probability estimates assembled from regulator-approved internal models of lending banks. The flattening of the line of best fit in this chart shows that, on average, compensation requirements per unit of default risk have fallen by about one-fifth since early 2016 (when our set of default probably data was first available).

Chart 1: CDS premiums vs. bank default probability estimates

Chart 2 compares CDS premiums with Altman z-scores. These combine several balance sheet and profitability metrics into a single indicator of default risk: the lower the score, the higher the risk of default. Except for firms with very remote default probabilities (z-scores above 3), this chart also suggests that compensation requirements per unit of default risk have fallen in the past couple of years. But they are not as low as in the run-up to the 2007-08 financial crisis.

Chart 2: CDS premiums vs. Altman z-scores

Harry Goodacre and Nicholas Vause work in the Bank’s Capital Markets Division

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Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

One thought on “Bitesize: Premium Delirium

  1. Great post.

    Is the difference between the regression lines in Chart 1 statistically significant?

    It looks like it is from eyeballing the chart. But it might be worth someone checking

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