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Difficulty: Moderate
1) Corporate debt levels were looking high even before Covid-19
2) High Yield default rates are expected to hit 9% over next 12 months
3) For defaulted High Yield bonds, recovery rates expected to average 30%
4) The Big Risk: Rating downgrades of BBB rated bonds to High Yield
5) IQ thinks that the High Yield bond market is unattractive at current credit spreads of 5.9%.
The InvestQuest’s View: We had published an article in mid-April suggesting that the High Yield bond market at >8% credit spreads looked attractive. Since then, we have taken profit on our High Yield bond exposure toward end-May, as credit spreads tightened below 7%. High Yield credit spreads have continued to compress further and at 5.9% now, we think that the risk-reward is poor, given current expectations of default rates for the year ahead.
We participated in a webinar hosted by Professor Edward Altman this week to glean some insights on the current state of the High Yield bond market.
For those who find his name familiar, that’s because he came up with the Altman Z-score, a commonly used financial metric to predict the risk of a company going bankrupt. It might surprise you that the Altman Z-score was published in 1968 and still used to this day.
We will highlight some of the salient points that he discussed, much of which may be found in greater detail in his recent publication “COVID-19 And The Credit Cycle“.
(Optional) Recap of what are High Yield bonds
According to Investopedia, high-yield bonds or “junk” bonds, are corporate debt securities that pay higher interest rates because they have lower credit ratings than investment-grade bonds.
Investment grade bonds will have credit ratings of BBB- or higher, while high-yield bonds will have credit ratings of BB+ or lower. To give some examples of corporate long-term credit ratings (from S&P) as at time of writing:
- Investment-grade
- BBB+: Standard Chartered, Credit Suisse
- BBB: AT&T, HP Inc, Barclays
- BBB-: Boeing, Marriott
- High-yield
- BB+: Ford Motor, Softbank Group
- BB: Delta Airlines, Under Armour
- BB-: Carnival Corp, MGM Resorts International
- B+: Bed Bath & Beyond, L Brands (Victoria’s Secret)
- B: Jaguar Land Rover Automotive, Kaisa Group
- B-: American Airlines, US Steel Corp
1) Corporate debt levels were looking high even before Covid-19
As of Dec-2019, US Corporate Leverage was at its highest level since 1987. In this case, “US corporate leverage” was measured by US corporate debt divided by GDP.
US Corporate Leverage is represented by the blue line in the chart below.
Despite the relatively high level of US Corporate Leverage, High Yield bond default rates (red dotted line in the chart below) remained low at just 2.87% in 2019, which was below the historical average of 3.3%.
It’s not shown in the chart, but at the end of 2019, High Yield markets were pricing in a benign credit cycle for 2020, with credit spreads trading at approximately 100bps below historical average.
Note: “US Corporate Leverage” was computed using US Non-Financial Corporate Debt (NFCD) divided by US GDP
Altman observed that when US Corporate Leverage peaked (blue line), US High Yield default rates (red line) peaked within 12 months later. He was observing data from 1987 to 2019, during which the recessions were as follows: 1) the Gulf War, 2) the Dotcom Bubble and 3) 2008 Global Financial Crisis.
As at Dec-2019, US Corporate Leverage had reached levels higher than the prior three peaks, which Altman viewed as excessive…
And this was before Covid-19 concerns arrived.
2) High Yield default rates are expected to hit 9% over next 12 months
Professor Altman used three methods to forecast High Yield default rates for the year ahead. A brief summary of each method may be found in the Appendix below.
Averaging the three methods, his preliminary forecasted default rate is 8.01% as of Mar 2020, for the upcoming 12-month period.
He added a further 1% to the default rate projection. This was to account for the risk of significant downgrades of BBB rated bonds into High Yield.
This brings his forecasted default rate for 2020 to about 9%.
Professor Altman’s forecasted High Yield default rate of 8-9% is largely in line with consensus views.
3) For defaulted High Yield bonds, recovery rates are expected to average 30%
When bonds default, it does not mean that you will lose the entire principal. During a debt restructuring or corporate bankruptcy process, shareholders will typically take losses first, followed by preferred shareholders/perpetual bondholders, then other unsecured bondholders.
Historically, owners of defaulted bonds have recovered 46% of the bond’s face value on average, according to Professor Altman.
Periods with high bond default rates tend to coincide with lower recovery values on defaulted bonds. Professor Altman compiled annual data of High Yield bond default rates with the corresponding recovery rates of defaulted bonds from 1982-2019.
Based on the observed relationship, he estimates that a 9% default rate would imply a ~30% recovery value on defaulted High Yield bonds in 2020.
Data spans 1982-2019 and is dollar-weighted.
4) The Big Risk: Rating downgrades of BBB rated bonds to High Yield
According to Professor Altman, there was US$2.5 trillion of BBB rated US corporate bonds as of December 2019 (52% of investment grade US corp debt). This is a marked increase from the 2007 credit bubble year, where there was “only” about $700 billion BBB rated debt outstanding (36% of investment grade US corp debt in 2007).
The explosive growth of the BBB market is a concern. Credit downgrades of BBB rated bonds into the High Yield space can increase the probability of High Yield default.
Professor Altman estimated that 34% of these issuers were at risk of being downgraded to High Yield (19% of these issuers to BB and 15% of these issuers to B). He arrived at this figure after subjecting a sample of 298 BBB+, BBB and BBB- rated corporate bond issuers to the Altman’s Z-Score models.
Do note that the above data does NOT yet factor in the negative impact of Covid-19 on corporate balance sheets. The data used for the exercise is as of end-2019.
Assuming 20-25% of BBB rated corporate bonds are downgraded to High Yield status in 2020-2021, this would imply US$500-625 billion of new fallen angels. US$500-625 billion would represent about a 33-42% increase of the current US$1.5 trillion US High Yield debt market.
Such a phenomenon may result in a higher default rate scenario than what the market is expecting.
Others are less pessimistic. Just this week, Bank of America lowered their forecast for US fallen angels to US$175bn (from US$200bn) previously, which is roughly one-third of Professor Altman’s estimate. This includes the US$123 billion of new fallen angels that have already been downgraded since the end of February 2020, implying “only” another US$50 billion of BBB downgrades are left.
5) IQ thinks that the High Yield bond market is unattractive at current credit spreads of 5.9%
US High Yield credit spreads currently stand at 5.9%.
This is above the 15-year historical average of 5.3% (chart below), but does not mean that High Yield bonds are cheap now. One must also take into account expected losses from potential bond defaults. Higher expected default rates (i.e. greater risk) should translate into higher credit spreads (cheaper valuations).
Professor Altman’s forecasted High Yield default rate of 9% is significantly higher than the 3% historical average. Furthermore, Professor Altman’s figure is relatively in line with consensus.
The current yield to maturity for an average High Yield bond is at 6.2%. This is based on: 5-year US Treasury yield of 0.3% + High Yield credit spread of 5.9%.
Assuming a 9% default rate and 30% recovery value on defaulted bonds that Professor Altman had estimated, we should expect average High Yield credit losses of 6.3% (9% default rate * 70% principal loss on defaulted bond).
As a result, assuming that risk-free treasury yields and credit spreads remain constant for the year ahead, your expected return for an average High Yield bond should be -0.1% (6.2% minus 6.3%), which makes High Yield relatively unattractive to me now.
The InvestQuest’s View: We had published an article in mid-April suggesting that the High Yield bond market at >8% credit spreads looked attractive. Since then, we have taken profit on our High Yield bond exposure toward end-May, as credit spreads tightened below 7%. High Yield credit spreads have continued to compress further and at 5.9% now, we think that the risk-reward is poor, given current expectations of default rates for the year ahead.
APPENDIX: Methods used by Professor Altman to forecast High Yield bond default rates
I have tried to summarize the steps for each method used by Professor Altman in a reader-friendly format. The full details may be found on page 7 to 9 of his publication.
- Mortality rate approach
- Compile historical data of bonds that have defaulted within 10 years of bond issuance. Aggregating this data (by credit rating) will give you the historical probability of a bond of a specific credit rating, defaulting “x” number of years after its issuance (results in table below).
- Compile the list of bonds issued in the past 10 years, sorted by credit rating. Apply the bond default probability statistics computed from the earlier step.
- Aggregate the dollar amount of expected bond defaults for the subsequent year and divide it by the forecasted population of High Yield bonds to obtain a forecasted default rate for the year ahead of 5.75%.
- Do note that this method does not incorporate current market conditions, so the forecasted default rates will be on the low side.
- Yield spread method
- Observe the historic annual relationship between credit spreads and High Yield bond default rates (a year later).
- A regression of the above variables result in an estimated Default Rate (a year later) = -3.15 + 1.28 * Current Credit Spread.
- Plugging in the yield spread as of March 26, 2020 of 9.84% results in a next 12 month forecast default rate of 9.45%.
- Distress-ratio method
- Observe the historical relationship between “Distress-ratio” (percentage of bonds trading >10% credit spreads, as a proportion of the entire High Yield bond market) and High Yield bond default rates (a year later).
- A regression of the above variables result in an estimated Default Rate (a year later) = 0.923 + 0.24 * Distress-Ratio
- Plugging in the distress ratio as of March 26, 2019 of 33% results in a next 12 month forecast default rate of 8.84%.
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