Fixed-Income Insights
What High Yield Valuations Are Implying About the Forward Corporate Default Rate
The current market environment is leading many credit investors to more closely examine default and recovery expectations.
In fast-moving and choppy market environments like today, it can be worthwhile to consider the question: “What’s in the price?” Credit investors are compensated for a number of risks and factors through a credit spread above and beyond the yield on risk-free benchmarks. They can include compensation for relative liquidity, credit quality changes brought about by both management actions, or the operating environment itself, and of course default risk. Further, investor sentiment and flows can play a role in driving credit spreads in the short term. For strategic investors with a long term mindset, we believe default and recovery estimates are the key considerations in determining appropriate spread levels.
Chart 1. Looking at Pricing from a Default Perspective
Severe default outcome already priced in to high yield spreads
Source: Moody’s and Lord Abbett. Data as of 12/31/2019. Implied default analysis assumes 5-year term and 30% recovery.
Past performance is not a reliable indicator of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
In the chart above, we address these key variables by approximating the implied cumulative default of a hypothetical credit portfolio of five-year maturity, assuming 30% recovery. Specifically, we run sensitivities around the implied default expectations in a portfolio at credit spreads of +600 basis points (bps), +800 bps and, +1000 bps. For example, at a spread of 800 bps, our analysis suggests that this level of credit spreads could be considered “fair value” should 42% of the issuers in a hypothetical credit portfolio default over five years. Keep in mind that the current spread on the ICE BofA US High Yield Constrained Index is right around there as of March 18 (+841 bps).
Next, we then chart out the cumulative default experience for a number of starting cohorts that were the source of periods of rising defaults in the high yield market: January 2000, January 2007 and January 2014. A few points worth noting on each period (utilizing default data from Bloomberg):
- 2000: This cohort’s default experience resulted from the leverage built up in credit markets leading to Y2K, the tech boom, outsized capital spending in the telecommunications sector and the ultimate failure bourn of accounting scandals at WorldCom and Enron. Notably, this is the most severe of the three cycles we considered – actually worse than the cumulative corporate default experience around the Global Financial Crisis.
- 2007: This cohort’s defaults were again driven by corporate leverage built up pre-crisis from the climb in leveraged buyout (LBO) activity, outsized corporate spending, debt financed share buybacks and the financial crisis that resulted from the troubles in the global banking system, U.S. housing market, and with consumer balance sheets.
- 2014: This cohort’s defaults were driven by leverage that largely built up in a few specific sectors, namely: energy, mining and to a lesser extent, retail. Note that the cumulative default experience in the five years that followed was not all that far off from the average default experience seen over five year periods using data from 1920. No recession ensued as the credit damage was largely contained to a small segment of the economy.
A Final Word on Market Pricing Considerations
At prevailing credit spreads, investors are bracing for almost twice the cumulative corporate default experience that eventually occurred around the Global Financial Crisis. Of course every cycle can be different, and much of the market’s reactions around 2008 were about systemic counterparty and banking system issues, not corporate credit. There is much still to be determined about the amount of economic output and growth ”lost” versus ”delayed” given the current macro environment. But we believe it’s always important to calibrate what the market is already priced for and consider if that outcome should be a base case assumption about the picture going forward.
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 article 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.
Glossary of Terms
A basis point is one one-hundredth of a percentage point.
The fair value of a bond is the present value of the bond's coupon interest payments plus the present value of the face value payment at maturity, discounted at the market's required rate of return for the bond in question.
“LBO” refers to leaveraged buyout.
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.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
ICE BAML US High Yield Index tracks the performance of US dollar denominated below investment-grade corporate debt publicly issued in the US domestic market.
ICE BofAML Index Information:
Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML 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 BofAML 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, OR ANY OF ITS PRODUCTS OR SERVICES.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The credit quality of the securities are 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 principle on these securities.
The opinions in this article 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.