We’ve always viewed default risk as one of the primary risks in high yield investing.  Unlike stocks, bonds have an end date and value via their maturity date and maturity price of par.  There may be a lot of price noise in a bond along the way, but over time the price would generally drift toward this maturity price as you get closer to the maturity date, or even higher toward a higher call price if an early call is expected.  However, a default (or distressed exchange) would be something that derails this end return.

Defaults certainly need to be considered as investors allocate money to the high yield market, or any fixed income security for that matter.  However, in assessing default risk, investors need to consider the potential default losses in the context of the yield being generated by the portfolio.  Yield can potentially go a long way in making up for default losses.  For instance, if the market as a whole is offering higher yields, investors can withstand a larger amount of default losses and may still generate what we would see as a decent return.  This is an important consideration as investors evaluate today’s high yield market, as we believe the yield currently offered by high yield bonds more than compensates investors for default risk.

Let’s evaluate some theoretical scenarios.  We’ll look at a high yield portfolio in which the underlying securities have an average price of $90 (90% of par), maturity of five years, coupon of 7.25%, and annual current or distribution yield of 8% for the initial year.  If we assume the portfolio appreciates in equal dollar annual installments to move from the $90 price (90% of par) on the underlying securities to a maturity price of $100 (100% of par) by the end of the five years and we assume all income is reinvested immediately, we get the following theoretical return scenarios:¹

Then if we factor in some sort of default assumptions on top of that, the theoretical returns are as follows:²

So even in a very dire 10% default rate and 25% recovery per year for five years, a theoretical 1.5% annualized return is generated, and if that recovery on the 10% default rate per year moves toward historical levels of 40%, a theoretical 3.1% return is generated, which is twice what is currently offered by 5-year Treasury³.  Never in the history of the high yield market have we seen defaults stay at double digit levels for multiple years in a row.  Even during the financial crisis, we saw default rates hit all-time highs for about a year, but then quickly fall to historically low levels for many years to follow⁴, so by no means do we see this multiple years at a 10% default rate as a realistic scenario.

We’ve seen projections for US corporate default rates ranging from 4%-6% in 2016, depending on whose numbers you use.⁵  If we take the midpoint, in the scenario above, assuming a 5% default rate per year for the next five years and 40% recovery, the theoretical annual return would be around 6.4%.  This may well be too conservative given, again, we haven’t seen this many sustained years in a row of higher defaults and it doesn’t account for any early calls at premiums for the holdings, which is potential upside.

Furthermore, the projected default statistics of around 5% are looking at the corporate debt market as a whole.  Yet, energy and commodities are about 16.6% of the high yield indexes⁶ and defaults in these sectors are expected to see a huge spike, while the rest of the high yield market is expected to remain at below average default rates.  So if you are able to build a portfolio with much less commodity and energy exposure than the general market, then your default and loss rates may well be lower.

With the yields offered by today’s high yield market, we believe investors are more than compensated for the default risk ahead, especially for active managers who can reduce their allocations to the most vulnerable securities/sectors, namely in energy and commodities.  We believe investors have the potential to generate what we see as an attractive return in today’s high yield market even in the face of increasing default rates.

1  These calculations are hypothetical and are provided for illustration only. Actual results may be materially different. These calculations assume all holdings mature in exactly 5 years and do not account for the fact a portfolio would have debt securities with various maturities or early redemptions via call or otherwise may occur.  These calculations assume that the price appreciation is equally distributed per year over the entire five year period, moving the price on the underlying securities from $90 (90% of par) to $100 (100% of par), so assuming a $90 portfolio value, it would increase $2 per year to total a portfolio price value of $100 at the end of year five.  These calculations also assume that the 7.25% coupon on par remains constant on a percentage basis, while the current yield decreases as the portfolio price as a percentage of par increases.  Coupon income generated is assume to be immediately reinvested a the current portfolio price as a percentage of par.  These assumptions do not account for fees, expenses, price variations, and yield variations, among other factors, and assume that no companies default on their principal or interest obligations or that securities are bought or sold over the holding period.

2  These calculations are hypothetical and provided for illustration only. Actual results may be materially different. These calculations evaluate specifically the potential loss rate relative to the accreted portfolio value (moving from 90% to 100% of par in equal installments over five years, with the value adjusted for par loss rates) 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.  Default losses are assumed to occur at the end of the year for each annual period and are accounted for as a decline in portfolio value.  Loss rates not default rates are used as any recovered value in the default is assumed to be available for reinvestment.  Recoveries are assumed to be immediate.  These scenarios also include the same assumptions noted in footnote 1, with various adjustments made due to par loss rates and do not account for fees and expenses.

3  5-Year US Treasury rate as of 4/7/16.

4  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, February 26, 2016, p. 45.

5  For instance, Credit Suisse projects 5% (Fer Koch, Miranda Chen, James Esposito, and Amit Jain, “US Credit Strategy Outlook,” Credit Suisse Fixed Income Research, December 21, 2015, p.18), J.P Morgan projects 6% (Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” March 1, 2016, p. 5) and we’ve seen rating agency projections closer to 4%.

6 Based on the J.P. Morgan US 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 and Leveraged Loan Research, March 18, 2016, p. 49.