Assessing Default Risk, Yields Matter
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (HYLD)
The most important risk to consider when investing in the high yield market is the risk of default. While there may be price volatility along the way, as we are currently seeing the space, bonds have a stated maturity and call prices and dates and, as long as they don’t default, bond prices generally move towards these par or greater prices over time as they get closer to the designated dates. Basically, there is an end prospective return that can be calculated for holding to maturity/call, but expected defaults also need to be considered. So as investors evaluate the high yield market and understand their risks, some math helps.
For the last couple years, we have seen default rates around 1.5%, but that is expected to tick up this year and into next year as the energy and commodity sectors face a wave of defaults. But keep in mind, just because a company defaults, that doesn’t mean that the bondholder completely loses all of their money. In fact, most bondholders do recover something as the bankruptcy is worked through or a distressed exchange is undertaken. The historical recovery rate for the high yield market over the last 25 years is about 40%, meaning holders will recover 40% of par. More recently this year, as the defaults have been substantially dominated by energy and commodity credits, we have seen recovery rates fall below 30%, as recoveries in the energy space especially have been well below average levels.1
As investors evaluate their holdings and assess their default risk, it is important to not only consider the default rate and recovery rate expected, but also the starting yield for the portfolio. Below we chart some scenarios under which we look at the sensitivity of the portfolio starting yield under various default scenarios with default rates ranging from 1.5-10% and recoveries of 25% and 40%.2
What’s important to keep in mind is that higher starting yields can go a long way in covering defaults (all else equal). For instance, in the chart above you can see that a portfolio yielding 5% and facing the most conservative 1.5% default rate and 40% recovery rate, produces an adjusted yield of 4.10%, which is even less than the 4.5% adjusted yield theoretically produced by the most aggressive scenario for the portfolio yielding 12%, whereby we look at a 10% default rate and 25% recovery rate.
In fact, this understanding that higher yields can more than compensate for the higher default risk was at the core of the origination of the high yield market. As we profile in our piece “The New Case for High Yield”:
The earliest modern era data we have on the high yield market came in 1958, when W. Braddock Hickman, a researcher for the National Bureau of Economics Research, produced a seminal piece of work entitled Corporate Bond Quality and Investor Experience. As the title suggests, he reviewed the corporate bond market and investors’ experience with it from 1900-1943. Hickman used the terms “low grade” and “high grade” to differentiate what we now refer to as “high yield” and “investment grade.” His conclusions were as follows:3
On the average and over long periods, the life-span yields realized on high-grade bonds were below those on low-grade bonds, with the result that investors, in the aggregate, obtained better returns on the low grades….The finding that realized returns were higher on low-quality corporate bond issues than on high-quality issues has implications for investment theory as well as for practical investment policy.
Hickman’s findings turned everything about investing in fixed income on its head. His conclusion was unmistakable in that low-grade bonds outperformed high-grade bonds over this period. The increased default rates of lower yielding paper were more than offset by higher-coupon income and recovery rates on the defaulted bonds.
While these findings were for the first half of the 20th century, we have seen this continue to play out within the modern high yield market. High yield bonds have outperformed investment grade corporates over various periods during the last 30 years, even accounting for the greater default loss rates.4
Of note, this idea that increased default loss rates may be more than offset by the higher coupon income doesn’t just translate to the high yield market versus investment grade, but we believe is also very applicable as investors evaluate lower yielding versus higher yielding portfolios and vehicles within the high yield market itself. The math clearly shows that higher yields can go a long way in offsetting default losses.
As we consider the default scenarios above, we evaluated some conservative scenarios versus more aggressive scenarios, so just where do we expect defaults to go? For the past few years, we have seen default rates around the 1.5% level, well below historical averages around 4%. The highest annual default rates on record were 10.3% back in 2009.5 As we look forward, we certainly don’t expect to get near these all-time high levels, though we do expect defaults to increase from the historically low levels of the past few years as the energy sector accounts for about 13-15% of the high yield indexes6 and we don’t believe many of these companies will survive the current bout of weak energy pricing. This is precisely the reason we substantially lowered our own energy industry exposure earlier this year. We’ve seen projections that defaults in the energy and commodity space will spike to double digits, while the rest of the high yield market will stay around that 1.5% level. So given the large exposure the high yield indexes have (and many of the products that track them) to energy and commodities, the projections are that this translates to total market default rates of 3-4%.7 That seems pretty reasonable to us.
Just because a product or vehicle reports a higher yield, that doesn’t necessarily mean it has a higher risk and thus a lower potential return prospect; investors should account for what that yield looks like after adjusting for expected default and recovery rates. As we look at the high yield market today, we see very attractive yields and spreads, which we believe are more than compensating for the expected default risk—in other words, even factoring in the expected default loss, we see attractive yield to be had in this market. Additionally, with active investing, we believe that managers can work to maximize that yield relative to the expected risk. So as investors evaluate their investment options within the high yield market, be it index based, passive products or active products, it is important to not only consider the yield and their own subjective assessment of risk, but also consider the math behind yields and default losses and what sort of adjusted yield that translates to.
1 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, November 2, 2015, p. 8.
2 These calculations are provided for illustration only. Actual results may be materially different. These calculations evalute specifically at the potential loss rate and do not consider any further portfolio factors or changes, such as the variability of prices and yields of non-defaulted and defaulted securities or the time frame for bankruptcy work out, among various other factors.
3 Hickman, W. Braddock, 1958. “Introduction and Summary of Findings.” Corporate Bond Quality and Investor Experience, partial text from pages 14-15. Princeton, NJ: Princeton University Press for National Bureau of Economic Research.
4 For the trailing period ending October 31, 2015. Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital).
5 Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 10, 2015, p. 4-5.
6 J.P. Morgan High Yield Index: Acciavatti, Peter Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, October 23, 2015, p. 52. Bank of America Merrill Lynch High Yield index, data sourced from Bloomberg.
7 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, November 2, 2015, p. 8.