Credit Deteriorates, Spreads Stay Tight

Rarely are the markets and the experts more divergent than when it comes to the issue of credit quality. The premium that investors charge for buying the riskiest debt is lower than it has ever been in the past, despite the fact that everybody seems to think that things are going to get worse, rather than better.

A couple of interesting datapoints came out today. First Euler Hermes, the world's largest credit insurer, said that its Global Insolvency index is likely to rise by 7% in 2007, after falling by 17% in 2006. Then Kamakura released its index of troubled companies, saying that it had increased for the third consecutive month. The low point, 5.4%, was reached in March-May 2006; now 7.1% of all global public companies are considered troubled, and the trend is clearly getting worse.

I'm beginning to think that the markets have come to the conclusion that money is so cheap that even bankruptcy is no big deal any more. Your debtor has run out of money? No problem – just lend him some more, and he'll be able to pay you back! Maybe the reason for the record-tight credit spreads is that investors are pricing in not a lower default probability, but rather a much higher recovery rate if and when defaults occur.