As we assess potential value in the high yield bond market, we believe it is important to consider both spreads and expected default rates. Current spreads offered by the high yield bond market are well above average and are now at multi-year highs, but is that just because we expect defaults to increase, so these levels are justified? We need to look at what the current spread levels imply in terms of default rates relative to expected default rates to properly answer that question. J.P. Morgan presents the math on the implied default rates based on current spread levels:¹

Current spreads are implying that default rates will be 6.6%, well above the historical default rate averages around 4% and well above the default estimates we have seen for 2016 ranging from about 3-4% (versus the default rate around 2% this year).²

What I think is most significant is looking at the breakdown of implied defaults for energy and ex-energy. Implied energy defaults of 14.4% don’t appear too off the mark, as we have seen projections in the low-double digits with the caveat that the default rate could increase if oil stays sub-$40. As we have spoken about at length before, we believe there are many high yield issuers at risk in the shale exploration and production segment of energy, as well as companies that provide services to these producers. With the high decline rates and capital costs in shale production, we expect liquidity to become tight in many cases, and are already starting to see defaults in the segment pick up. We are currently avoiding shale energy producers because of the unfavorable dynamics we see in the space.

However further looking at the breakdown of the implied defaults for the rest of the high yield market excluding energy it is way off the mark by our assessment. Default projections we have seen range from about 1.5-2% for the vast majority of the market that excludes energy, less than half of what the current spreads would imply as a default rate. Given this, we believe the current dynamics in the high yield market present an environment where active management is essential. This is a bifurcated market with the vast majority of the market that has relatively solid fundamentals and offering what we see as sizable discounts and yields in many cases. And then there is a segment of the market where extreme caution is warranted.

With the implementation of the Volcker Rule, the outflows that we have seen from the asset class, and all the negative headlines, we have seen prices in much of the broader high yield market fall for what we see as no fundamentally driven reason. Unlike prior downturns where we saw widespread credit issues and over-levering, we aren’t seeing that today. Other than in a couple selective industries, we see today’s high yield market as having a pricing problem not a credit problem. We believe this has created one of the better opportunities we have seen in our careers to enter the high yield market or add to your allocation. With spreads at multi-year highs, we believe there is value to be had for investors in this market but active management and a focus on fundamentals will be key to investing in the space as we enter 2016 and beyond.

1 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2015, p. 112.

2 See our piece “High Yield Bonds: The Energy Dilemma” for further detail on default projections.