Thursday, March 24, 2016

While the Shorts are Getting High on Valeant...

The last ten days have been miserable for shareholders of Valeant (VRX), investors in its debt, or believers in (insurers of, or "sellers of protection" on) its creditworthiness.  

The stock is down >50% over the last ten days.  Accounting statements are said to be unreliable; the CEO and CFO are no longer there, with the CFO having been accused by the company of improper conduct. The list goes on.  Investor Bill Ackman has been recently appointed to the board (arguably a credit positive).

Just about a year ago in March 2015, Valeant raised millions of dollars from debt investors, with ratings of B and B1 being provided to their debt by S&P and Moody's, respectively.

Already denoted as being of somewhat high risk, it was interesting to visit the responses of market participants (traders), and compare them to those of the rating agencies, on receiving the never-ending slew of incoming bad news.

Credit default swap (CDS) spreads widened dramatically on Valeant (reference obligation US91911KAE29) in the last 10 days. See the spike on the right of the following Bloomberg graph. 

At a 40% recovery, CDS-implied default probabilities more than doubled from 5.7% to 13.2% on the 1-year, and cumulative default probabilities jumped from 37.3% to 55.2% on the 5-year trades.

Meanwhile, the rating agencies were less alarmed, and their response more tepid: Moody's downgraded Valeant bonds one rating subcategory from B1 (watch negative) to B2 (watch negative); S&P simply placed the bonds (downgraded to B- from B in October) on downgrade watch.

To put the difference into perspective, we wanted to draw a relationship between the CDS-implied default probabilities and rating agency-implied default probabilities.  

We'll do this for Moody's, by way of their idealized default rate tables.

Valeant Starting to Look Like a Triple C Basket Case

In the 1-year CDS, now at 13.2% from 5.7%, the market is now no longer seeing this as a B1/B2 risk  (close to Moody's rating) as it did on March 14, bur rather closer to a B3/Caa1 credit as of March 24.

The pattern is even more dramatic for the lengthier term 5-year CDS: at the 55.2% CDS-implied cumulative default probability, the market is seeing the credit risk as closer to the Caa2/Caa3 range.

Right now, the market is saying that there's chaos at Valeant.  Moody's and S&P aren't so sure.

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