Much has been made about the outlook for defaults in the high yield market. Many have speculated that we are at the beginning of a big upturn in that default cycle and thus, this market should be avoided. While this makes for good headlines, the projections we’ve seen, and our own expectations, don’t add up to a big uptick in default rates. Yes default rates will likely increase, but remain below historical averages for the high yield market.

Of note, prior to 2008, on average we have generally seen a lag between declining returns/spread widening and the default rate, meaning we would see spreads widen ahead of a default rate uptick, with a 7-month lag pictured below. And during the 1986-2008 period, the average difference between spreads and default rates was 290bps, also pictured in Exhibit 1.1

However since the 2008 recession, we have seen this relationship breakdown, with several periods of spread widening that did not correspond to an increase in default rates. Additionally, that difference between spreads and the average default loss rate has expanded significantly, to 479bps. As noted above, that 189bps increase in the average difference over the past six years is attributed to an additional liquidity premium. All this to say, it is reasonable to assume that just because spreads have widened over the past few months, it doesn’t necessitate that a big default uptick is on the horizon and we believe that today’s high yield investors are getting paid to take on liquidity risk, not fundamental/default risk for most of the high yield market. As an investor, we would much rather capture fear and liquidity related widening, not fundamentally and default driven spread widening, and see liquidity premiums as an opportunity for increased value for investors.

Subscribe to our free daily newsletters!
Please enter your email address to subscribe to ETF Trends' newsletters featuring latest news and educational events.