We notice that periods of high defaults tend to cluster together (in a very similar way to volatility). These spikes in default rates correspond to well-known periods of recession:
- The Great Depression during the 1930s
- The relatively mild recession of 1969-1970
- The early 1990s recession
- The tech crash of the early 2000s (before which the telecommunication-media-telecom sector represented up to 40 per cent of high yield indices)
- The “Great Recession” between 2007 and 2009
However, it is worth noting that not all recessions have coincided with spikes in default rates. For example, between WWII and 1968 (during the ‘Trente glorieuses’), default rates remained very low, but there were five recessions according to the NBER count.
That being said, since credit investors generally own bonds or CDSs with a maturity of 5-10 years, we should look at cumulative prospective default rates of 5-10 years rather than 12-month trailing default rates.
If we analyse the data shown above, we can make at least three observations:
1) Since 1920, average high-yield spreads (5.02%) have been much higher than average annualized default losses (1.73%), implying an average risk premium of around 3.30% per year. Capturing this risk premium was actually the sales pitch used by Michael Miken in the early 1980s to promote high yield bonds. However, as we will see, this risk premium has receded since the mid-80s.
2) The range of default losses is much more limited than the range of credit spreads (which went up to 20% in 1932 and 2008). Credit spreads clearly overshoot when times are bad.
3) Finally, we can observe that there is no visible link between spreads and 5 yr forward default losses, especially when we consider the period since 1970. This implies that, despite their alleged high degree of sophistication, credit investors have a very weak predictive power on future default rates. This is confirmed by the following regression analysis:
Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.
As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors. The last three decades gave investors three extraordinary opportunities to expose themselves to credit risk, as credit spreads reached levels that made no economic sense (we believe that average high-yield spreads above 1000bp are irrational, unless we’re on the verge of a global catastrophe that would wipe out the entire economy).
As of end of February 2013, the situation is obviously much less clear-cut.
US high yield spreads (CDX HY) are currently around 435, close to European Crossover spreads (455).
From our point of view, these spread levels are still attractive from a static valuation point of view, since they correspond to an annualized implied default probability of around 7% over the next 5 years.
These default rates have only occurred twice during the last 100 years:
From a valuation standpoint, we believe that there’s still at least a 50bp spread tightening potential for both US and EUR High Yield.
When it comes to high yield bonds however (which are still the main instrument through which investors gain corporate credit exposure), many commentators lament on the low yields that are currently being offered (less than 6%).