Understanding Two Key Dimensions of U.S. Credit Spreads | Lord Abbett
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Fixed-Income Insights

While credit spreads have tightened, we believe lower default risk to come, and the resulting, reasonable liquidity compensation means valuations are well supported by fundamentals.

Read time: 8 minutes

In Brief

  • Default data over the last 40 years shows cumulative default intensity peaking at lower levels with each credit crisis. We view factors such as the maturation and increasing efficiency of financial markets, the targeted nature and growing potency of monetary policy, and the improved, overall credit quality of the high yield market as ongoing contributors.
  • Other than the period right before the Global Financial Crisis (GFC), the high yield market has consistently priced in a higher default experience over the coming 12 months than has actually been realized.
  • Compensation above and beyond default losses eventually incurred by investors in both the high yield and leveraged loan markets has been reasonably consistent over time, and with each other.

Despite interest-rate volatility sourced from a raging debate on inflation for much of this year, U.S. risk asset markets have generally continued their healing. Persistently strong U.S. economic data have lent validity to investors largely putting the worst of the pandemic behind them. Within U.S. credit markets, investment-grade credit spreads are about 10% tighter than where they troughed pre-pandemic, and high yield credit spreads are just about there. That’s led many investors and asset allocators to wonder if any opportunity remains within credit generally, and more specifically within high yield. Often viewed as the barometer of overall risk appetite, high yield spans the near investment-grade profile of BB-rated issues and the equity-like characteristics of CCC-rated issues.

We’ve previously advocated considering a strategic allocation approach to high yield for attractive income in a portfolio (or multi-sector product), as opposed to tactical timing, while also retaining a positive view on the asset class as part of our 2021 investment outlook. But in this note, we take a closer look at the components of the overall high yield credit spread, and consider why an allocation to leveraged credit more broadly is still warranted.

Lower Default Cycle Peaks Over Time

At the onset of the pandemic in early 2020, broad swaths of investors and strategists believed that the last 12-month (LTM) default rate on high yield bonds would rise to 10-15% or beyond by year-end, consistent with peak levels in prior recessions. But as we’ve noted before, the credit quality of the high yield market has consistently improved over the past decade. When combined with 2020’s swift and outsized monetary and fiscal stimulus, the LTM speculative default rate peaked at just over 6% at year-end 2020, per JP Morgan data, substantially short of the estimates noted above. And it resides at just 3.2% as of April 30, 2021.

Looking back further in Figure 1, we track the forward, cumulative five-year default rate by ratings cohort. For example, the latest data point in the chart represents the cumulative default count of the 2016 cohort. Notably, cumulative default losses are lower, given recoveries greater than 0%. We should expect this measure to turn lower over the coming year, in line with the turn of the one-year default rate as noted above. Forecasting aside, what’s clear is that the peak in the cumulative default tally has been moving lower with each successive default wave. 

 

Figure 1. Default Cycles Peaking at Lower Levels from One to the Next
Cumulative 5-year forward default experience by ratings cohort, December 1980-December 2020

Source: Moody’s Annual Default Study 2020. Data as of 12/31/20. Most recent full year data available. Subject to change based on changes in the market. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Why Might Default Cycles Be Turning Less Intense?

  • As noted earlier, the increase in the composite ratings of the high yield market, now majority BB-rated, suggests an overall shrinking of the pool of potential default candidates, as management teams look to optimize capital structures durable enough to withstand various market environments and exogenous shocks, just like we had in 2020.
  • The rise of the private credit market may have aided in this positive selection bias with smaller, less liquid issuers accessing that alternate pool of capital.
  • Increased regulatory oversight of the banking system, post the 2008-09 global financial crisis, contributed, leading to a general reluctance by supervised banks in extending credit in the leveraged loan market to highly levered entities (for reference, see this 2013 bulletin from the U.S. Office of the Comptroller of the Currency).
  • Monetary policies targeted to smooth over public market discontinuities have become increasingly innovative—and potent—as deep recessions are perceived as suboptimal from a public policy perspective.
  • The broadening and deepening of financial markets, including distressed rescue capital, and a general reduction of frictional costs in the banking system are all creating multiple potential pools of capital for stressed borrowers.
  • The secular decline in interest rates has favorably supported debt service levels, all the while aiding investor appetite in a declining yield environment.

Forecasting the Default Rate Through a “Distressed Ratio”

What’s the collective marketplace suggesting about defaults from here? We define the distress ratio as the percentage of the face value of bonds in the high yield market trading at a credit spread over 1,000 bps (basis points) at any point.  The intuition here is that investors collectively could be highlighting potential default candidates among those with elevated credit spreads. In Figure 2, we track the fraction of the realized forward 12-month default rate versus the distress ratio. A few points worth noting:

  1. Outside of the period just leading into the 2008 Financial Crisis, the 12-month forward default rate to the distress ratio has consistently been below 100%. Simply put, the market has pretty regularly overestimated the value of the high yield market’s face value that would ultimately default in the coming 12 months.
  2. The average reading over the period has been 45%, and the median has been 36%. In other words, generally less than one half of the value of the high yield market seen at risk of default ended up defaulting over the coming year. The exception was the lead-up to the GFC when the distress ratio troughed at 0.65% in June 2007 (and the ICE BofA U.S. High Yield Constrained Index spread was at 251 bps or approximately 100 bps tighter than today’s level).

 

Figure 2. Distressed Valuations Consistently Overestimate Realized Default Rate

Ratio of 12-month forward default rate for U.S. high yield bonds to the distress ratio (as defined), December 1999-December 2019

Source: Moodys' Annual Default Study 2020, ICE Data Indices LLC and Lord Abbett. Data as of 12/31/20. Most recent data for forward 12-months available. The ratio is calculated by using the actual forward 12-month default rate versus the distress ratio (the percentage of the face value of bonds in the high yield market trading at a credit spread over 1,000 basis points). The data account for default activity through 12/31/20. Subject to change based on changes in the market. The historical data are for illustrative purposes only, do not represent any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

For current context, the distress ratio was 2.25% as of April 30, 2021. Conservatively assuming that a full 100% of this identified value-at-risk actually ends up defaulting over the coming year, the ICE BofA U.S. Distressed High Yield Index priced at approximately $78, and an unsecured recovery assumption of 30%, the default loss would be just over 1% (or 108 bps), comfortably below the current level of spreads in the high yield market. This reasonably simple approach should help put some perspective around current pricing, exhibiting once again how credit investors are still potentially overpaid for default losses to come in the year ahead.

Estimating the Ex-Default Loss Compensation in a Credit Spread, or “Liquidity Risk”

An examination of appropriate pricing of credit risk can serve as worthy fodder for a PhD dissertation. That’s not our intent here. Instead, we target the discussion by simply considering a credit spread to be a creditor’s compensation for 1) loss given default as discussed in the prior section (“default loss”), and 2) all other risks, such as being short a put option to management teams that could result in creditor-unfriendly corporate actions like leveraged buyouts; other credit deterioration; and general financial market risk premia, etc. We’ll simply call this latter collective component, “liquidity risk” compensation. As noted earlier, we argue that loss given default could potentially move to a structurally lower level than it has been historically, both from some lower intensity of default outcomes but also from some uplift from here in recoveries, as history suggests default rates and recoveries are inversely related. But how has this second component, liquidity risk compensation, evolved over time in the leveraged finance markets?

We can compute this catch-all of liquidity risk compensation by taking the difference between a credit spread index and estimated annual default losses in both the high yield bond and leveraged loan markets. In Figure 3, we track our estimates of liquidity risk compensation (or excess spread) through time for both asset classes. Some worthy observations follow:

  • Despite evolving investor dynamics, market structures, and issuer compositions, the leveraged loan and high yield markets’ liquidity risk premiums are quite similar in magnitude and direction of movement over the entire period.
  • However, the liquidity risk compensation in the leveraged loan market was generally below the high yield market pre-GFC, but greater in the years that followed. Why? This likely has to do with the reality that CLOs (collateralized loan obligations) have been an increasingly bigger proportion of the holder-base of leveraged loans over time. This relative shrinking of the aggregate size of the retail mutual fund holder-base of leveraged loans to CLOs has served as a headwind at times in secondary market trading liquidity. Additionally, the increasing proportion of lower rated, private and/or loan-only capital structures in the loan market led bank loan investors to require wider spreads.    
  • The unexpected nature of the 2020 pandemic, tighter starting spreads in the high yield market than in the loan market in the year prior to the onset of the pandemic, and a modestly higher default loss intensity in the high yield bond market during 2020, in comparison, collectively led to a negative liquidity risk premium for bondholders during 2020. In other words, and only in hindsight, high yield investors weren’t fully compensated for default losses to come from 2020’s exogenous shock of COVID-19 by prevailing credit spreads in late 2019.  

 

Figure 3. Comparing Bank Loan and High Yield Bond Liquidity Risk Premium Over Time

Excess spreads in U.S. high yield and U.S. leveraged loan markets (as defined), January 2000-April 2020

Source: Moody’s, JPMorgan, Credit Suisse Leveraged Loan Index, ICE BofA U.S. Constrained High Yield Index, and Lord Abbett. Data as of 4/30/2020. Most recent 12-month forward data available. Excess spread is estimated to be the amount of compensation an investor received in either the high yield or leveraged loan markets in the form of a credit spread, after accounting for estimated default losses over the coming 12 months. The historical data are for illustrative purposes only, do not represent any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Anyone who has examined credit spreads knows that there is an art and science to it. “What’s the right liquidity risk premium?” is the art, while the science comes from figuring out “What’s in the price from a default loss perspective?”  Figure 4 shows how this liquidity risk premium has been related to the level of prevailing high yield spreads at each point in time since 2000. Intuitively, at wider spreads, investors’ compensation for liquidity risk grows materially, increasingly overcompensating for any estimate of default losses to actually come over the next 12 months. The sole exception again, as seen in the chart, comprises the months just ahead of the 2020 pandemic, highlighting the surprise nature of the eventual market stresses and default activity created by the pandemic.

 

Figure 4. How Estimated Liquidity Risk Premiums Vary with Prevailing Credit Spreads

(January 2000 – April 2020)

Source: Moody’s, JPMorgan, Credit Suisse Leveraged Loan Index, ICE BofA U.S. High Yield Constrained Index, Lord Abbett. Data as of 4/30/20. Most recent 12-month forward data available. The historical data are for illustrative purposes only, do not represent any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Summing up

Putting it all together, here’s the state of high yield valuations today, in our view:

  • Using the approach of looking to the distress ratio as a guide, we estimate default loss over the coming 12 months of approximately 1% or less.
  • With the ICE BofA U.S. High Yield Constrained Index spread of approximately 350 bps today, that default loss estimate would imply a residual liquidity risk compensation of approximately 250 bps. This residual is very much consistent with the liquidity compensation in the high yield market when spreads have been at similar levels in the past, as seen in Figure 3. Moreover, the Fed’s (Federal Reserve) playbook in action and the dominance of refinancing activity in the new issue market during both 2020 and year-to-date 2021 may argue for an even lower liquidity premium going forward.

Ultimately, there are any number of factors that frame the discussion around how credit investors should be compensated. Our work here is to simply provide a framework to highlight why we are still compelled to maintain today’s levels of corporate credit exposure in our multi-sector fixed-income strategies, despite the recovery in credit spreads to pre-pandemic levels. Yes, in the summer months ahead, the potential for rate volatility to rise again may give credit markets pause, but the secular drivers of owning corporate credit in multi-sector strategies remains firmly in place. 

 

 

DISCLOSURE

A Note about Risk: A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

No investing strategy can overcome all market volatility or guarantee future results.

Value at risk (VaR) is an estimated measure of the risk of loss of an investment. It is defined as the maximum dollar amount expected to be lost over a given time horizon, at a pre-defined confidence level.

 

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

The ICE BofA U.S. High Yield Constrained Index is a rules-based index consisting of U.S. dollar-denominated, high yield corporate bonds for sale in the U.S. The index is designed to provide a broad representation of the U.S. dollar-denominated, high yield corporate bond market. The index is a modified market value-weighted index with a cap on each issuer of 2%. The ICE BofA CCC U.S. High Yield Constrained Index, the ICE BofA B U.S. High Yield Constrained Index, and the ICE BofA BB U.S. High Yield Constrained Index are ratings-specific subsets of the index.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated, leveraged-loan market.

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstance.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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    Understanding Two Key Dimensions of U.S. Credit Spreads

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