Recent market turmoil highlights the vulnerability of the financial markets. October has followed a volatile path with the S&P 500 dropping precipitously mid-month and the S&P U.S. Issued High Yield Corporate Bond Index following course. The S&P U.S. Issued Investment Grade Corporate Bond Index was up during this time as investors undertook a flight to quality. Investment Grade securities have since pulled back from mid-October gains to sit just slightly above the High Yield universe at 1.07% versus 1.27% as of October 27th. But both are relative winners over equities which have lost .44% on a total return basis month-to-date, despite recent positive momentum.
This pull back was preceded by increasing credit risk appearing in the fixed income universe during the third quarter. S&P Capital IQ’s Probability of Default (PD) Model Market Signals produces daily credit risk assessments from the equity markets. We display weekly snapshots of this indicator for North American companies below. By this metric, credit risk has increased by 60.6% on a median basis during the third quarter. This was led by a steep increase over the last three weeks of the quarter after credit improvements in August.
For a longer term trend, we look to our fundamental-based probability of default (PD) indicators. We observe an improving trend with declining median PDs on a quarter-over-quarter basis in Q4 2013 and Q1 2014. However, they have deteriorated through the second and third quarters of this year, increasing by 1.21% and .72% on a median basis, respectively. This signal shows a more measured change than the market-based PDs, but keep in mind this is based upon issuer fundamentals and as such, is a medium-term signal.
We have seen both the signals exhibit increasing credit risk within the fixed income markets during the third quarter. We have also observed similar risk signals from several other credit risk indicators.