On the average and over long periods, the life-span yields realized on high-grade bonds were below those on low-grade bonds, with the result that investors, in the aggregate, obtained better returns on the low grades….The finding that realized returns were higher on low-quality corporate bond issues than on high-quality issues has implications for investment theory as well as for practical investment policy.
Hickman’s findings turned everything about investing in fixed income on its head. His conclusion was unmistakable in that low-grade bonds outperformed high-grade bonds over this period. The increased default rates of lower yielding paper were more than offset by higher-coupon income and recovery rates on the defaulted bonds.
While these findings were for the first half of the 20th century, we have seen this continue to play out within the modern high yield market. High yield bonds have outperformed investment grade corporates over various periods during the last 30 years, even accounting for the greater default loss rates.4
Of note, this idea that increased default loss rates may be more than offset by the higher coupon income doesn’t just translate to the high yield market versus investment grade, but we believe is also very applicable as investors evaluate lower yielding versus higher yielding portfolios and vehicles within the high yield market itself. The math clearly shows that higher yields can go a long way in offsetting default losses.
As we consider the default scenarios above, we evaluated some conservative scenarios versus more aggressive scenarios, so just where do we expect defaults to go? For the past few years, we have seen default rates around the 1.5% level, well below historical averages around 4%. The highest annual default rates on record were 10.3% back in 2009.5 As we look forward, we certainly don’t expect to get near these all-time high levels, though we do expect defaults to increase from the historically low levels of the past few years as the energy sector accounts for about 13-15% of the high yield indexes6 and we don’t believe many of these companies will survive the current bout of weak energy pricing. This is precisely the reason we substantially lowered our own energy industry exposure earlier this year. We’ve seen projections that defaults in the energy and commodity space will spike to double digits, while the rest of the high yield market will stay around that 1.5% level. So given the large exposure the high yield indexes have (and many of the products that track them) to energy and commodities, the projections are that this translates to total market default rates of 3-4%.7 That seems pretty reasonable to us.
Just because a product or vehicle reports a higher yield, that doesn’t necessarily mean it has a higher risk and thus a lower potential return prospect; investors should account for what that yield looks like after adjusting for expected default and recovery rates. As we look at the high yield market today, we see very attractive yields and spreads, which we believe are more than compensating for the expected default risk—in other words, even factoring in the expected default loss, we see attractive yield to be had in this market. Additionally, with active investing, we believe that managers can work to maximize that yield relative to the expected risk. So as investors evaluate their investment options within the high yield market, be it index based, passive products or active products, it is important to not only consider the yield and their own subjective assessment of risk, but also consider the math behind yields and default losses and what sort of adjusted yield that translates to.