We recently discussed how not enough is written about the yields in the market currently versus spreads and why yields are far more important for calculating defaults.
We think this raises a larger question of whether the frameworks people use to look at high yield are correct. The annualised default rate is an incredibly important factor for valuations, but we don’t believe historical default rates are applicable for two reasons:
- The current market weighted high yield coupon is 5.3% (versus a market yield of 3.8%); over the last 20 years this had not dropped below 7.8% until 2013. Since 2013 the average default rate is 2.8%, compared to a 4.5% default rate for the 13 years before that, but the 20-year average is skewed for those earlier defaults, giving us an overall default rate of 3.8%.
- Defaults were incredibly high in high yield at the turn of the millennium (between the end of 2000 and start of 2004 the rate averaged 8.5%) as the cohort at the time was dominated by early-stage telecom and media infrastructure credits. The average of 3.8% disguises the fact that the default rate since the start of 2004 has been just 2.9%.
Figure 1: Default rate for all sectors across global high yield
Source: S&P, as at 31 March 2021
What does this mean for valuations?
Well with a 60% loss rate, a 3.8% annualised default rate leads to a 2.3% annualised loss, while a 2.8% annualised rate gives you a 1.7% loss. That’s a default rate change that should mean spreads are 60bps tighter on average in the current period.
When you add in a better rated cohort, a larger market, and better liquidity (see our recent post on High yield valuations here), we think historical comparisons are not applicable. If we think back to 2007 and think how tight spreads got across credit in an environment where risk free rates were higher, we think with an implicit central bank put, valuations have room to get even tighter from here.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.