Tuesday, December 7, 2010

Junk bond default rates have plunged

Today Moody's announced that "the trailing 12-month global speculative-grade default rate dropped to 3.3% in November 2010. A year ago, the global default rate stood much higher at 13.6%." Moreover, Moody's is now forecasting that this same default rate "will fall to 2.9% by the end of this year before declining further to 1.8% by November 2011." "Measured on a dollar volume basis, the global speculative-grade bond default rate remained unchanged at 1.4% from October to November. Last year, the global dollar-weighted default rate was noticeably higher at 19.6% in November 2010."

The improvement in just the past year is remarkable: "A total of seven Moody's-rate corporate debt issuers have defaulted in November, which sends the year-to-date default count to 52. In comparison, a total of 257 defaults were recorded in the comparable time period last year."

Here's the reason behind the improvement: "Corporate defaults are falling as profits surge, the economy recovers and debt markets allow even the riskiest borrowers to raise record amounts of cash. Junk-rated companies have sold $97.8 billion of bonds globally since September, putting issuance on pace to beat the record $99.8 billion raised in the third quarter, according to data compiled by Bloomberg."

The above chart shows the average yield on junk bonds, currently 8.2%. The dramatic decline from the unheard-of-before peak of 25% is simply breathtaking. This improvement also owes much to accommodative monetary policies all around the world. Easy money is a debtor's best friend, as they say.

This next chart shows the spread on high-yield CDS, which also shows dramatic improvement—and, more importantly, room for more, especially since default rates continue to decline. To date, the generous spreads on junk bonds have helped insulate this market from the rather dramatic increase in Treasury yields. Since the end of August, when QE2 was first floated, 10-yr Treasury yields are up over 60 bps, yet junk bond yields have fallen by about 30 bps.

Even if 10-yr yields rise further—as I expect they will, since the economy is continuing to grow and Obama's long-awaited decision to go bipartisan on the issue of taxes should impart some genuine growth stimulus to the economy, and forward-looking inflation expectations have risen from 2% in August to almost 3% today—I note that junk yields traded around current levels back in the first half of 2007, when 10-yr Treasury yields were over 150 bps higher than they are today. To pass up 8% yields on junk bonds in favor of cash yielding almost zero is equivalent to saying that all h*ell is going to break loose at any moment.

Full disclosure: I am long TBT and long various high-yield mutual funds at the time of this writing.


Bill said...

Why are you in high yield mutual funds instead of high yield junk bond ETFs?


John said...

I would suggest that the very same factors Scott points out would apply to financial institutions such as banks and insurance companies. Credit quality has been improving consistently for several quarters. Many of these companies are still not out of the woods but improvements are clear.

Markets will not wait for the facts to be obvious to all. Financial securities are underowned and trading well behind the rest of the market. I continue to expect them, as a sector, to outperform the S&P in 2011.

Scott Grannis said...

Bill: sorry, I meant to say ETFs, with my favorite being HYG.

John: I agree completely.

TD said...

Would you sell naked puts on the S&P right here? That chart of Junk Yields is identical to a chart of the Vix. Owning high yield is identical to selling CDS on the crappiest credits. It makes sense sometimes, but it sure doesn't here, IMO.

septizoniom said...

the vast majority of the issuance is refinancings and term extensions effected by very speculative grade credits, supported by hy mutual funds and other investors lunging for yield. this is not indicative of anything other than that. the default rate has plunged because of the access to the refi. very little is for new growth or to new companies. most issuers today are past repeat credits, and sponsor driven at that. the balance is private equity driven lbo (new or acquistions through portfolio companies of private equity shops).
i know all this to be true as i analyze the data from bloomberg and lcd on this.

it actually is a sign of great distress that rates are this low for speculative grade credits, not a sign of strenght.

please don't give unsophisticated readers who look at this blog such poor investment advise as "don't pass up high yield"

Benjamin Cole said...

Good news. I liked HYG too, but my wife wanted a house.

My wife won.

John said...

Septi's comment above I think is a commonly held belief among many investors (I am not trying to be critical here) and I wanted to comment earlier on it but couldn't seem to find a good way to say it.

Randel Forsyth's daily column in Barrons online today addresses it well..."High yield bonds ain't junk anymore". He quotes a Wells Fargo fund manager who rather agrees with Scott's opinion. But he points out that the "lunacy of past cycles was largely absent in this one" and "the...irony is that the worst credit bubble and collapse in history involved mortgage backed securities with a AAA imprimatur." Another point was that the most refis done in the sector have been to lower cost of capital and extend maturities, not to go on questionable buying sprees. Hardly the stuff of increasing default risks.

I have long thought that 'subprime' and 'junk bonds' do not deserve the negative connotations they recieve from many investors. As long as they are SOLD as subprime and PRICED as subprime the risks are reasonably definable. Its when subprime is dressed up as AAA and priced as something it isn't that investors get into trouble.

Lower grade fixed income investing is not for everyone. But if everyone sees it for what it is, most folks can come to their own conclusions as to whether it suits them or not.