FLASH UPDATE: High Yield Defaults are Minuscule - Are You Comfortable?

“When the default tidal wave eventually hits, it will be very big,” said Marty Fridson, CEO of FridsonVision, LLC.  Mr. Fridson expects $1.6 Trillion (face), or $752 Billion (market value), of high yield corporate debt to default between 2016 and 2020.  This implies a 30% default rate cumulatively over that four year period.  The global default rate in junk bonds fell to 2.8% at the end of December 2013.  By way of comparison, according to Moody’s, the global high yield default rate finished 2007 at 0.9% and subsequently peaked at approximately 19% at the end of 2009.  The average default rate over the last 25 years is approximately 5.0%. 

In the last 25 years, every period of sustained default rates below 5.0% have resulted in multi-year periods of default rates that exceed 10% (see Chart 1).  Low current default rates are a poor barometer of a company’s ability to survive.  At the end of December, the spread between junk bonds and Treasuries broke below 400 bps for first time since July 2007 and the spread between junk bonds and investment-grade bonds hit all-time tight levels.  High yield companies have had incredibly cheap and nearly unfettered access to capital in the recent easy money environment.  Despite this access, many of the lower-tier companies in the high yield universe have been unable to compete with their peers, grow the top-line, innovate, generate positive cash flow or EBITDA.  Taking all of this into account, combined with the unprecedented record high yield bond issuance over the last two years (see Chart 2), it is quite clear that junk bond investors are being paid very little to take on a huge amount of default risk. 

Chart1

Chart 2

Tradex has done a tremendous amount of research on the lower tier of the junk bond universe, with a particular focus on single-B and CCC-rated bonds.  Historically, academic studies show that (on a cumulative basis) more than 45% of CCC rated bonds default within 4 years of issuance.  We agree with Mr. Fridson’s default forecasts and think that the ability to identify and be short of worst-of-the-worst, highly levered, longer-dated, subordinated or unsecured junk bonds in the lower-rated tier will be an incredibly successful strategy over the next five years. 

Richard Travia

Director of Research