Moody’s this week released their expectations for their global speculative grade default rate. Their default model is now (rather belatedly) indicating that there is to be a surge in defaults through this year, with the global speculative grade (ie ‘high yield’) default rate peaking at 15.4% in November 2009. Moody’s use a 12 month trailing default rate, so what they are saying is that 15.4% of the global high yield market will default in the year to the end of November 2009.
The thing that caught our eyes was the jump in Moody’s expected default rate. As this chart shows, only one month previously, Moody’s expected a peak of 10%. It’s worth adding, though, that November’s forecast appeared far too low, especially if you consider that as at the end of November, euro high yield bonds yielded almost 22% more than government bonds, and US high yield bonds yielded 20% more than Treasuries (both figures already implying roughly an annual default rate of 16-17%, and that’s assuming a zero recovery rate). In fact, the market doesn’t seem too bothered by Moody’s updated forecast – high yield spreads have actually tightened a bit since the end of November (the respective figures were 19% for euro HY and 17% for US$ HY as at yesterday)
How does a 15% annual default rate compare to the Great Depression? This chart shows Moody’s speculative grade default rate going back to 1920. The annual default rate peaked at 16.3% at the end of 1933, so not quite as bad. But the figures aren’t really directly comparable. The high yield market didn’t exist as such in the 1930s – companies that were rated sub investment grade were ‘fallen angels’, ie companies that were formerly investment grade. Junk companies only started issuing bonds en masse during the Milken years of the 1980s, and the European high yield market didn’t start developing until the mid 1990s. A better comparison would be the default rate seen in the early 1990s and particularly 2001-02. We concur with Moody’s that default rates should exceed those levels.
But remember, high yield spreads are massively wider than they were in the 1990s and the early ‘noughties’. The high market is already pricing in a default rate significantly higher than Moody’s is expecting. We are seeing some attractive valuations in the high yield market, and are chipping away at the better quality end where mandates allow. However we do expect defaults to surge, and particularly from the end of 2009 when a lot of high yield names need to refinance. We also expect defaults to be concentrated in companies that were LBOd in 2006-07 and in cyclical names, and defaults will be very heavy in the poorer rated names (so CCC rated bonds are still basically a no go area for us).
Finally it was interesting to note the Chapter 11 filing of Nortel this week, which was an event that bond markets had priced in since November. Nortel is a company that survived the 2001-02 tech wreck, but hasn’t made it this time. This is a good example of why we aren’t piling into high yield right now. We remain very bearish on the global economy, with the recession/depression likely to be worse than the early 1990s and obviously much worse than the non-recession of 2001-02. The high yield market hasn’t ever been tested by a 1981-82 recession or a 1974, nor even a 1932. So maybe two thirds of the high yield market really could go bust in the next five years (which is about what the bond market’s actually pricing in). That said, if you can avoid the companies that do default, then the potential returns are clearly considerable.