By Sujata Rao and Thyagaraju Adinarayan
(Reuters) - The coronavirus outbreak that has led people to cancel holiday plans, movie outings and business travel is raising the risk of default by some of the worst-hit companies, an index widely used as a barometer of European corporate debt sentiment suggests.
The Markit iTraxx Europe Crossover index of five-year credit default swaps - which measures the cost of insuring exposure to a basket of junk-rated companies - surged on Friday to 380 basis points, the highest since June 2016.
Constituents of the index include household names such as Air France (PA:AIRF), ThyssenKrupp (DE:TKAG), Fiat Chrysler (MI:FCHA) and Marks & Spencer (L:MKS).
Based on index pricing, the default probability of some of these firms is as high as 30% over the next five years.
"What we are seeing is a natural market reaction to the potential hit to companies' cash flow generation for 2020," said Ed Eyerman, managing director at Fitch ratings.
(GRAPHIC: Cost of insuring junk-rated European debt rises png - https://fingfx.thomsonreuters.com/gfx/editorcharts/EUROPE-MARKETS-CDS/0H001R8F0C6M/eikon.png)
(GRAPHIC: Shares of highly-levered EU companies - https://fingfx.thomsonreuters.com/gfx/buzzifr/15/8585/8585/Pasted%20Image.jpg)
The surge in the crossover index may spook many, who will recall it blowing out to over 1,000 bps in the run-up to the 2008 crisis that eventually resulted in double-digit default rates in the junk sector .
The Crossover index, which comprises credit default swaps (CDS) of 75 sub-investment grade European firms, allows investors to buy or sell protection on all the constituents with a single trade - essentially a short (or long) bet on the junk bond market.
"The move in CDS reflects a grab by trading desks and funds for a hedge," said James Tomlins, co-manager on M&G Investments' global high-yield bond fund. "It's difficult to trade large volumes in European high-yield, so rather than sell cash bonds, you just buy protection."
CDS trading volumes were far higher than in the corporate bond market, he added.
The index does not contain many names which are already experiencing high levels of distress, such as Norwegian Air (OL:NWC), which saw shares collapse on Friday to 15-year lows.
Already-troubled UK airline Flybe has also gone into administration.
Tomlins said it had become clear recovery would take longer, and that market stress was skewed towards some sectors such as consumer discretionary and travel.
The moves have happened fast as the virus spread across Europe and the United States - the index was at 303 bps last Friday, and has almost doubled from end-2019 levels.
The index pricing implies a 30% probability for Air France to default over the next five years, while German steel firm Thyssenkrupp is seen with a 17% chance.
The latter has roughly 16 billion euros ($18.1 billion) in debt and pension liabilities, more than twice its market value.
(GRAPHIC: Companies with high chances of default - https://fingfx.thomsonreuters.com/gfx/buzzifr/15/8587/8587/Pasted%20Image.jpg)
Interest rates at rock-bottom and falling could cushion the blow. U.S. rates were cut by half a percent this week and euro zone and UK rates may follow suit. Fiscal stimulus and government bailouts are also possible.
Default rates for European junk credits are currently around 2.5%, Eyerman of Fitch said. That may rise, he said, adding that he had asked his ratings analysts to "assume additional stresses" due to the virus.
($1 = 0.8853 euros)