Last week, we posed the following question: Does the current spread of the high yield market adequately compensate investors for the risks they’re taking? In this blog, we further discuss the potential for defaults over the medium-term, which is a key factor in answering the aforementioned question.
We believe that the outlook for defaults over the next 12-to-18 months is extremely favorable and the high yield bond market default rate will fall well below the historical average of 3.1%. Forecasts for the default rate have been declining in recent months, with some recent forecasts for 2021 now coming in below 1%. The primary driver of such a low default rate is the level of fundamental improvement expected in the market as a result of the strong economic growth forecast. Additional factors include expectations that new issue markets will remain very active with high refinancing volume, the small volume of defaults that have already occurred this year, and the low total amount of bonds currently trading at stressed or distressed prices that would indicate a high likelihood of default.
While default rates below 1% are rare, such an outcome has occurred before. More precisely, over the 39 years of historical data available, a total of four calendar years have recorded default rates below 1%. A default rate below 1% is also supported by another common method for forecasting defaults, which is to assume that all bonds trading at distressed levels (i.e., prices below $70, which generally signals that the market expects such bonds to default) will default. Per analysis by JP Morgan published in mid-June, the total principal amount of high yield bonds trading in distressed territory was only $10.5 billion, representing only 0.7% of the total high yield market. This is the lowest total principal amount of distressed bonds in over 10 years, falling well below the amount trading in such territory before the pandemic-induced market selloff in March 2020.
As of this writing, we believe that high yield market spreads adequately compensate investors for the risks associated with investing in such a market. However, I have not touched on the effect that spreads at these levels could have on high yield market performance. As a general takeaway, one should not assume that spreads at current levels guarantee that the high yield market will generate a negative return or that the asset class will underperform equities on a forward 1, 3, or 5-year basis.
That said, the sample size of environments in which spreads have been at these levels unfortunately is simply too small to draw any meaningful conclusions. As of June 30, 2021, the option-adjusted spread on the ICE BofA U.S. High Yield Index was 305 basis points. There have been only two periods over the historical timeframe for which spread data is available beginning in January 1997 where spreads on this index fell below 300 basis points for a meaningful period of time (i.e., more than two months).
The first period occurred in January 1997 and lasted almost a year and a half. During this time period, the high yield market generated positive returns but underperformed equities, as represented by the S&P 500 and Russell 2000 indices, over the next 1, 3, and 5-year periods. The second period began in December 2006 and lasted almost seven months. High yield again generated positive returns over the following 1, 3, and 5-year periods. Relative to equities, performance was mixed on a one-year basis, while on a 3 and 5-year basis, high yield outperformed the S&P 500 and Russell 2000, which both experienced negative returns over the following 3-year periods and were essentially flat over the 5-year period.
There are limited conclusions that can be drawn from this narrow set of data, as ultimately no one can predict with any degree of certainty the future relative or absolute performance of the high yield market in this type of environment. Accordingly, as an investment manager, we should focus on what we can control, which is conducting exhaustive bottom-up fundamental research and due diligence on each potential and existing investment opportunity that we evaluate for inclusion in our client portfolios.
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.