The most important risk to consider when investing in the high yield market is the risk of default. While there may be price volatility along the way, as we are currently seeing the space, bonds have a stated maturity and call prices and dates and, as long as they don’t default, bond prices generally move towards these par or greater prices over time as they get closer to the designated dates. Basically, there is an end prospective return that can be calculated for holding to maturity/call, but expected defaults also need to be considered. So as investors evaluate the high yield market and understand their risks, some math helps.
For the last couple years, we have seen default rates around 1.5%, but that is expected to tick up this year and into next year as the energy and commodity sectors face a wave of defaults. But keep in mind, just because a company defaults, that doesn’t mean that the bondholder completely loses all of their money. In fact, most bondholders do recover something as the bankruptcy is worked through or a distressed exchange is undertaken. The historical recovery rate for the high yield market over the last 25 years is about 40%, meaning holders will recover 40% of par. More recently this year, as the defaults have been substantially dominated by energy and commodity credits, we have seen recovery rates fall below 30%, as recoveries in the energy space especially have been well below average levels.1
As investors evaluate their holdings and assess their default risk, it is important to not only consider the default rate and recovery rate expected, but also the starting yield for the portfolio. Below we chart some scenarios under which we look at the sensitivity of the portfolio starting yield under various default scenarios with default rates ranging from 1.5-10% and recoveries of 25% and 40%.2
What’s important to keep in mind is that higher starting yields can go a long way in covering defaults (all else equal). For instance, in the chart above you can see that a portfolio yielding 5% and facing the most conservative 1.5% default rate and 40% recovery rate, produces an adjusted yield of 4.10%, which is even less than the 4.5% adjusted yield theoretically produced by the most aggressive scenario for the portfolio yielding 12%, whereby we look at a 10% default rate and 25% recovery rate.
In fact, this understanding that higher yields can more than compensate for the higher default risk was at the core of the origination of the high yield market. As we profile in our piece “The New Case for High Yield”:
The earliest modern era data we have on the high yield market came in 1958, when W. Braddock Hickman, a researcher for the National Bureau of Economics Research, produced a seminal piece of work entitled Corporate Bond Quality and Investor Experience. As the title suggests, he reviewed the corporate bond market and investors’ experience with it from 1900-1943. Hickman used the terms “low grade” and “high grade” to differentiate what we now refer to as “high yield” and “investment grade.” His conclusions were as follows:3Showing Page 1 of 2