August 30, 2011
Default and recovery rate risks are low
The leading authority on the HY market is Edward Altman at the NYU-Stern School of Business. On Feb. 4, 2011, Altman’s group at NYU published a the latest installment of their annual report titled Defaults and Returns in the High-Yield Bond and Distressed Debt Market: The Year 2010 in Review and Outlook.
Altman’s work allows us to answer two obvious questions with regard to HY bonds. First, because HY bonds are yielding below their historical average over the past 30 years, one might question whether investors are getting too little reward for holding these risky bonds. Altman provided historical data on the yields of HY bonds and 10-year Treasury bonds going back to 1978. He also looked at the spread between HY and 10-year Treasury bonds as a measure of the risk premium that HY bonds provide. While the total yield on HY is low historically, the spread between HY and Treasury bonds is currently above its average from 1978 through 2010. The yield to maturity for HYG is 8.2%, while the YTM for 10-year Treasuries is 2.1%. The difference in yield, 610 basis points, is greater than the historical average yield spread of 5.22% reported by Altman.
The second question that arises with HY bonds is whether the level of default and expected recovery risk are increasing. Altman specializes in predicting the likelihood of corporate distress and default, and he addressed the problem of predicting default and recovery. First, he presented data that showed that one can predict recovery rates using default rates. He then combined three methods for predicting 2011 default rates and came up with an average forecast of 3.2% and recovery rate of 39.8%. This predicted default rate is below the historical annual average of 3.3% for HY bonds between 1971 and 2010, based on Altman’s data.
In the context of Altman’s 30+ years of data on HY bonds, the current yield spread is just slightly above average, the expected default rate is slightly below average and the expected recovery rate is slightly above average. There is no reason to believe that HY bonds are overvalued.
Given that the yield on HY bonds is disproportionately high relative to their current risk level, we can now apply Altman’s research to explore how high default rates need to be before HY bonds have the same yield versus risk of other fixed income classes and become unattractive. Using Altman’s data, the default rate must increase to 4.2% to bring HY bonds in line with other bonds. A 6.2% default rate would bring the effective yield of HY bonds down to that of long Treasury bonds. Even at a 4.2% default rate, HY bonds will be attractive to investors with the appropriate risk tolerance. For 2010, the default rate of HY bonds was 1.13%, but in 2009 the default rate was 10.8%, and in 2008 it was 4.65%. Prior to 2009, the last year with a default rate at 6.2% or above was 2002.
Conclusions
HY bonds have a 30+ year history of higher annual returns and lower risk levels compared to equity indexes. In addition, they are essentially uncorrelated to interest rates and provide a high level of income. Altman’s research shows that HY bonds do not face inordinately high default or recovery-rate risk. Options on HY bond ETFs provide forward-looking risk estimates showing that HY bonds are attractively priced.
Indeed, HY bonds may have already discounted economic risks that the equity markets have not. As Gluskin’s Rosenberg noted last week, there is a 60% chance of recession already embedded in HY prices, whereas the equity markets imply only a 30%-50% chance of recession.
Despite these attractions, HY bonds do not have a great deal of exposure in popular asset allocations. The growth in HY research and the increased transparency in risk levels (through ETF options) should encourage advisors to integrate HY bonds into their portfolios. Particularly as a large portion of the U.S. population is moving from the accumulation stage of their lives into the income-drawing stage, HY bonds deserve more attention.
Geoff Considine is founder of Quantext and the developer of Quantext Portfolio Planner, a portfolio management tool. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors
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