The chart above shows estimated losses on the recent credit spread movements on the corporate bond exposure of a firm like Just Group. First of all, let me state I have nothing against Just, which I am using as an example. My target, as always, is the regulatory system that approved the capital position of such a firm in the first place.
As is obvious, the swings in asset value are enormous. There are losses over 2018 because of spread widening, then spreads tighten again so that the losses are roughly recovered over 2019. The modelled losses broadly calibrate to Just Group’s income statement for 2018 and 2019. Then – as a result of the recent explosion of spreads in the corporate bond market, there is a mark to market loss of around £900m. That is, if the spreads had blown at before the end of 2019, the firm could have been facing a loss of about £1,200m, rather than the actual profit booked (after tax) of £302m.
As I say, the issue is not with this particular firm, but the regime. Why did the PRA approve a capital model giving a capital requirement (SCR) of £1,800m? The annualised volatility implied by the mark to market movements shown above is that amount to one standard deviation, i.e. a probability of default of 15% or 1 in every six years, not every two hundred years.
What has gone wrong? The classic “Sam Woods” defence is that mark to market changes caused by spreads are merely temporary – ‘artificial volatility’, and that spreads will soon narrow down again, don’t panic. But how do we know that spreads will narrow? Indeed, how do we know that the spread movements do not reflect fear of real and impending default? Witness the desperate situation of the aviation industry.
As I commented before, there is a significant risk that lower investment grade bonds will be downgraded into sub-investment grade, meaning the insurer will be forced to sell – either because of regulatory rules or because of internal covenants – and buy higher rated bonds at a higher price. This causes a realised loss that can never be recovered.
Or they may just default. Who can tell?