A record low decade for high yield defaults

Much of this is due to near record low government yields rather than extreme spread levels. Having said that, credit is being supported by the continuation of a low default period which was only briefly interrupted by the financial crisis.

Indeed 2012 was another year of below average default rates and we have now completed a full five-year cycle since the default rate picked up aggressively with the global financial crisis in 2008 after what had been a benign 2007, even given that this was the year that Northern Rock collapsed and the sub-prime crisis began.

It’s interesting to note that in spite of going through the most significant financial crisis since the “Great Depression”, default rates in the past five years in the 2008 cohort were only above their relevant long-term averages for Aa, single-A and Caa-C rating bands. The Baa, Ba and single-B rating bands all saw five-year cumulative default rates below their long-term averages. For Aa and single-A rated issuers, financials are the clear reason why the default rates have been above their long-term averages.

The 2008 cohort for the Baa, Ba and single-B rating bands would have had very small financial exposure and thus shows the purest measure of corporate ‘non-financial’ defaults since the crisis.

We look at the histories, by rating band, for these five-year cumulative default rates. This is based on data back to 1970.

Starting with investment grade, we can see that defaults in the 2008-2012 five-year cohort for single-A rated issuers were the highest in this 40+ year period which, from our experience of the annual data back to 1920, means that this is the highest five-year default cohort since the Great Depression in the 1930s. For Aa rated issuers, only the 1984-1988 cohort saw a fractionally higher default than that seen in the past five years.

For Baa, Ba and single-B rated issuers we see a much more benign scenario where the 2008-2012 default cohort saw a lower peak than that seen at the peak of both the early 1990s and early 2000s recessions.

Given the once in a lifetime stress seen during the global financial crisis this is remarkable.

Furthermore, it’s interesting to note that the default rate for single-A and Aa rated issuers during the crisis was actually higher than the Baa rated issuer default rate. For Caa-C rated issuers the data history is not as deep with the cohort data only exceeding 30 issuers after the worst of the early 1990s recession was behind us. However, the 2008-12 cohort also saw notably lower Caa-C rated defaults than seen during the early 2000s and early 1990s recessions.

The largest rating band in high yield – namely single-Bs – now sees its 10-year cumulative default rate drop to the lowest since 1977, before the high yield market really became established. There were 794 single B companies in Moody’s universe in 2003 when this 10-year cohort started (1,147 today) but only 31 in the 1977 cohort.

So in the modern era once the high yield market became a standalone asset class, rather than just a fallen angels market, the past 10 years has seen the lowest period for single-B defaults based on the 2003 cohort.

For Ba rated issuers the 1992-2001 cohort saw a fractionally lower default rate but outside of this the rolling 10-year default rate is at its lowest since the late 1970s. For Caa-C rated bonds we’re at the lowest rolling 10-year default rate since 1989 when there were only 12 issuers in the cohort as opposed to 298 in 2003 and 505 today.

Another way to examine the data is to look at annual default rates for each year.

In spite of a weak decade of US growth, even weaker European activity, the worst financial crisis since at least the 1930s and a high 2009 default rate, the past 10 years to the end of 2012 has seen a lower average annual default rate than the prior three for Ba, B and Caa-C rated issuers.

The overall high yield default rate has also been lower than the prior two decades which is impressive given the consistent fall in average rating of the universe as the market has grown and developed. If anything spreads across all rating bands have been slightly higher than their averages during this low period of defaults. So there is little evidence that they have responded to this lower default regime.

Jim Reid and Nick Burns are strategists in the Deutsche Bank fixed income research team. This is an extract from their annual Default Study 2013: Analysing a Decade of Record Low High Yield Defaults