Current high yield default rate forecasts are too low

In its press release as of 1/14/16, Moody’s stated that the global speculative default rate was at 3.4% and that projected default rate for 2016 was 3.9%.  It is interesting to note that in the 1/16/15 press release Moody’s projected a global speculative default rate for 1015 of 2.7%. 

JPMorgan (2016 High-Yield Bond and Leveraged Loan Outlook, 12/09/15) expected 10% Energy sector defaults at 15% market weight to add 1.5% to high yield bond (JPMorgan’s High Yield Index) defaults for the total of 3%; the assumption was that non-Energy subset would have a default rate of 1.5%. 

In our opinion those estimates are too conservative and high yield default rate will exceed its 20-year average of 4% leading to a negative total return for high yield bonds in 2016. 

Based on the Haynes & Boone survey published in OilPro last week (also available on Haynes & Boone’s website), the industry players (lenders and borrowers) are expecting 13% (see pie chart blow), which would be an underestimate as people are usually late in accepting reality. In addition, 15% expect to get funds from HFs and Pes, the funding sources when commercial secured lending is not possible, and the borrowers are at/near default. As you know most of those are structured as converts with certain covenants that when violated, debt is converted to equity (usually controlling) at the option of the lender. Therefore, we estimate that about a half of the companies in that 15% will default/restructure within 12 months (’16, ’17). We see the total Energy sector default rate going to 19-22% range in ’16. Using the JPMorgan’s methodology and our expectation of 2-2.5% for non-Energy defaults, 19-22% Energy default rate would contribute 2.9%-3.3% leading us to a 4.9% (conservative) - 5.8% (aggressive) range of high yield default rate estimate for 2016. 

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The total return is a sum of a coupon + price change. On 12/31/15 average coupon was 7.5%. The price change is a sum of expected change in credit spread and expected change in Treasury rates multiplied by duration.  At this we don’t see US Treasury spread changing much no matter what the Fed does/not do in 2016; so for simplicity, we will assume that number to be 0 basis points. Of course, if one believes that Treasury rates will go up, the price (of all fixed income instruments) will be negatively impacted. The corporate credit spread is roughly approximated by a product of expected default rate and (1 - recovery rate).  Historically, recovery rates decline during the periods of higher default rates negatively impacting change in credit spreads further. So, a negative several hundred basis change (current – forecast) in credit spread multiplied by 4.2 (duration) could easily lead to a negative price change greater than coupon of 7.5% and a negative total return for the year.

© 2016 Alex Rybchinsky

www.aremet.com

 

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Alex Rybchinsky

Alexander Rybchinsky is a Managing Director focused on our advisory practice in Greenwich, Connecticut. Most recently he was a Team Leader of Leveraged Finance Research at General Electric Asset Management. Prior to that Mr. Rybchinsky had worked for several leading institutional investment managers in the USA; he has over 20 years of leveraged finance experience including high-yield bond portfolio management, credit research, and trading. Mr. Rybchinsky holds a MA in Economics from University of Pittsburgh where he also received his BA (Magna Cum Laude) in Economics and was elected Phi Beta Kappa. Mr. Rybchinsky is a Chartered Financial Analyst (CFA) and a Chartered Alternative Investments Analyst (CAIA).