Why Have U.S. High Yield Default Cycles Ebbed? | Lord Abbett
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Market View

High yield bond default rates were lower than expected in 2020 and continue to decline. Lord Abbett’s leveraged credit expert explains why.

Read time: 2 minutes

In an upcoming article, Investment Strategist Riz Hussain takes a closer look at the components of the overall high yield credit spread, and points to the specific factors that contribute to U.S. high yield bond valuations. Here, Market View presents an excerpt spotlighting one of those factors, the default rate, and why it has trended lower in recent years.

Lower Default Cycle Peaks Over Time

At the onset of the pandemic early last year, investors believed that the last 12-month (LTM) default rate on U.S. high yield bonds would rise to 10-15% or beyond by the end of 2020, 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; as of April 30, 2021, it stood at just 3.2%.

For more historical perspective, Figure 1 tracks the forward cumulative five-year default rate by ratings cohort. For example, the latest data point in the chart below represents the cumulative default count of the 2016 cohort in the subsequent five-year period. 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 referenced above. What is clear is that the peak in the cumulative default tally has been moving lower with each successive recession-driven default wave. 

 

Figure 1. Default Cycles Peaking at Lower Levels from One to the Next
Cumulative five-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 fortify their capital structures.
  • The rise of the private credit may have aided in this positive selection bias with smaller, less liquid issuers accessing that alternate pool of capital instead of tapping the public high yield bond market.
  • Increased regulatory oversight of the banking system post the 2008-09 global financial crisis also contributed, in our view, leading to a general reluctance by supervised banks in extending credit in the leveraged loan market to highly levered entities.1
  • Monetary policies targeted to help public markets function properly have become increasingly innovative—and potent—as deep recessions are perceived as undesirable 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 companies’ ability to service debt, all the while aiding investor appetite in declining yield environment.

We believe the declining intensity in the default cycle over time is a key ingredient that further supports our continued positive outlook on the U.S. high yield bond sector.

Be sure to watch lordabbett.com in coming days to access the full whitepaper, “Examining Credit Spreads Through the Lens of Default and Liquidity Compensation”.

 

1Source: “Leveraged Lending: Guidance on Leveraged Lending,” U.S. Office of the Comptroller of the Currency, March 22, 2013.

 

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.

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 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.

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 circumstances.

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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