At the most basic level, the main reason corporate bonds, and high yield bonds in particular, pay a higher coupon than U.S. Treasuries is to compensate investors for default risk, or the potential loss of principal if the high yield issuer is unable to meet its debt obligations when they come due. Therefore, in determining whether the current spread of the high yield market adequately compensates investors for the risks associated with investing in such a market, the outlook for defaults over the medium term is the single most important factor needed to make such determination.
Since the start of the year, default rates in the high yield bond market have declined significantly, with the trailing twelve-month par-weighted default rate at 1.63% as of June 30, 2021. The default rate for calendar year 2020 was 6.16%. The significant decline in the year-to-date default rate is largely the result of default volume from the second quarter of 2020 being removed from the trailing twelve-month default total used in the calculation. That quarter represented the second highest quarterly default volume on record. In addition, the number of defaults and distressed exchanges in 2021 have been very low by historical standards, with the first six months marking the lowest default volume in the first half of a calendar year since 2011.The benign default environment this year is another reason that the high yield default rate has materially declined year-to-date. These are certainly encouraging figures; however, for an investor trying to determine whether current spreads provide sufficient compensation in light of the default risk present in the high yield market, it is critical to also assess the outlook for future defaults.
Before focusing on the default outlook moving forward, however, I believe that we should first acknowledge the rather unique events that have occurred in the high yield market over the past sixteen months. The coronavirus pandemic and the associated mitigation efforts enacted to address the public health crisis had a profound impact on the high yield market and specifically on the high yield bond default rate, the composition of the high yield market, and such market’s aggregate maturity profile.
First, there was a dramatic spike in defaults, particularly during the second quarter of 2020, resulting in the second highest volume of defaults during a quarter on record. Default volume during the other three quarters was significant enough that calendar year 2020 registered the second highest calendar year volume of defaults on record, trailing only 2009. This rise in the number of defaults effectively amounted to the removal of many of the riskier issuers from the high yield market (as a defaulted bond is no longer included within broad-based high yield indices).
While focusing on the rise in defaults and the accompanying effect on the composition of the high yield market is admittedly an oversimplification of what actually occurred, it does reveal important information. Issuers viewed as too risky by the market were unable to obtain necessary financing last year and subsequently defaulted and/or restructured their capital structures, thereby reducing their amount of debt to more sustainable levels. Meanwhile, issuers that were not deemed as having unsustainable debt balances were largely successful raising additional debt, often at elevated interest rates, to enhance their liquidity position in an effort to remain solvent during a time of extreme uncertainty.
Fortunately, thanks to significant fiscal and monetary stimulus by the proactive U.S. government, capital market conditions improved rather quickly, or else the level of defaults otherwise could have been much higher. The high yield new issue market, operating under the assumption that the Fed would quickly intervene if economic conditions deteriorated again, saw new issuance volume soar in the second quarter of 2020 – a trend that has remained largely unchanged through the first half of 2021. Over this period, refinancing activity in the high yield market surged as many high yield issuers refinanced their existing bonds to take advantage of the low-rate environment as well as extend their maturity profile. In addition, during this very issuer-friendly primary market, many high yield bonds have been issued with weaker covenant protections than what would be considered standard and certainly could result in some unpleasant consequences for some bondholders down the road.
As a result of the events described above, the high yield market now contains fewer issuers with unsustainable debt loads as well as less aggregate debt maturing in the intermediate term. All else equal, we should expect fewer defaults if the economy falls into a recession than would have been the case had the events of 2020-21 not occurred.
Next week, we will address recent forecasts for the remainder of 2021, some of which are predicting a default rate below 1%.
Interested in reading more? The above post is an excerpt from our 2021 mid-year CIO Perspective. We invite you to access the full document, available below.