The pricing of credit risk – Bank Underground

Barbara Jankowiak, Natan Misak and Nicholas Vause

Both financial market participants and regulators have suggested that investor risk appetite has declined since the beginning of the year. This post presents some evidence from credit markets consistent with such developments, and offers two possible explanations.

We build on analysis in an earlier post that looked at the relationship between credit default swap (CDS) premiums for insuring against potential losses due to the default of North American investment-grade (IG) companies and the default probabilities of those same companies as estimated by lending banks. Here, we show time series of the CDS premium per unit of default probability, not only for North American IG companies, but also for companies in Europe and with high-yield (HY) credit ratings.

As shown in Chart 1, there was a spike in this metric in March 2020, when risk appetite plunged amidst the onset of the Covid-19 pandemic, followed by a steadier and larger increase since the beginning of 2022.

Chart 1: CDS premium per unit of default probability

Sources: Credit Benchmark, Refinitiv Eikon from LSEG and Bank calculations.

Why might risk appetite have fallen during this more-recent period? One possible reason is that risk-free interest rates have increased, reducing the need for investors to move down the risk spectrum in a search for yield. A second possibility is that interest-rate volatility has increased, boosting the volatility of asset prices and, hence, investors’ existing portfolios. The correlation between the CDS premium per unit of default probability and the level and volatility of interest rates over this period can be seen in Chart 2.

Chart 2: Drivers of the price of credit risk

Sources: Barclays, Bloomberg, Credit Benchmark, Refinitiv Eikon from LSEG and Bank calculations.

(a) Average of the four series in Chart 1 showing the CDS premium per unit of default probability.
(b) Ten-year US dollar swap rate.
(c) Twelve-month implied volatility of ten-year US dollar swap rate from swaption contract (tripled to fit on the same axis).

Barbara Jankowiak works at Leeds University Business School, Natan Misak and Nicholas Vause work in the Bank’s Capital Markets Division.

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