Mid-Year High Yield Bond Market Default Review and Outlook

Coming off of a spike in total high yield bond default rates in 2016 due to a large number of energy, metals and mining, and other commodity related defaults, the expectation was for defaults to significantly ease heading into 2017.1

As we sat six months ago, the expectation was for defaults to be 2.5% in 2017 and 3.0% in 2018, versus a 2016 level of 3.6% (see our piece, “High Yield Default Rate: 2016 Review and 2017 Outlook”).  As we hit the midpoint for 2017, the LTM default rate has fallen to 1.3% as monthly default volume continues to trend downward.2

While some seem to be concerned about the impact of potentially higher interest rates on the high yield market, investors need to be aware that the biggest driver of spreads historically is not interest rates (interest rate risk) but rather the default rate and outlook (default risk).  As we look forward, the default rate expectations for full year 2017 and 2018 have fallen to 2.0% or lower versus an expectation of 2.5% for 2017 and 3.0% for 2018 six months ago.3

This puts the default rate and expectations well below the historical average of 3.3%.4

Credit/default risk remains at the core of spread movement and, as we look over the next 18 months, we believe that the benign default outlook bodes well for the high yield market. Even with the spread tightening we have seen so far this year, according to J.P. Morgan’s research, the implied default rate based on current spreads in the high yield bond market is 1.7% versus an actual default rate of 1.3%, or 1.77% if you include distressed exchanges, and an outlook of 2.0% or lower for the next couple years.5 So while some may argue that the high yield market is expensive based on the current spread level, in looking at them relative to default rates and expectations, it seems reasonably valued.  Additionally, we believe that adding an effective active management overlay on top of this can help to further stem default exposure and potentially improve spread/yield value.

1  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.
2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.
3  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” High Yield and Leveraged Loan Research, J.P. Morgan North American Credit Research, 6/16/17, p. 5-6, https://markets.jpmorgan.com/?#research.na.high_yield.
4  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.  Based on monthly LTM default rates from December 1998 through May 2017.
5  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” High Yield and Leveraged Loan Research, J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.
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