Much has been made about the outlook for defaults in the high yield market. Many have speculated that we are at the beginning of a big upturn in that default cycle and thus, this market should be avoided. While this makes for good headlines, the projections we’ve seen, and our own expectations, don’t add up to a big uptick in default rates. Yes default rates will likely increase, but remain below historical averages for the high yield market.
Of note, prior to 2008, on average we have generally seen a lag between declining returns/spread widening and the default rate, meaning we would see spreads widen ahead of a default rate uptick, with a 7-month lag pictured below. And during the 1986-2008 period, the average difference between spreads and default rates was 290bps, also pictured below.1
However since the 2008 recession, we have seen this relationship breakdown, with several periods of spread widening that did not correspond to an increase in default rates. Additionally, that difference between spreads and the average default loss rate has expanded significantly, to 479bps. As noted above, that 189bps increase in the average difference over the past six years is attributed to an additional liquidity premium. All this to say, it is reasonable to assume that just because spreads have widened over the past few months, it doesn’t necessitate that a big default uptick is on the horizon and we believe that today’s high yield investors are getting paid to take on liquidity risk, not fundamental/default risk for most of the high yield market. As an investor, we would much rather capture fear and liquidity related widening, not fundamentally and default driven spread widening, and see liquidity premiums as an opportunity for increased value for investors.
While default rates as a whole are expected to remain below average for the next couple years, expectations are for a meaningful increase in defaults in certain sectors, namely energy and commodities. For instance J.P. Morgan expects total default rates of 1.5% this year and to remain at 1.5% next year excluding energy, but 3% for the entire market on the back of a 10% default rate for energy,2 compared to historical average default rates around 4% for the high yield market. This projection seems pretty reasonable to us. Energy makes up about 13-15% of the high yield indexes, depending on which index you use, and metals and mining about 3-4%.3 So together, we are looking at about 16-19% of the total high yield indexes as extremely vulnerable to default given today’s oil and various other commodity prices. We are in the midst of the shale boom bursting and there will be casualties. In looking at the 21 companies that have defaulted year-to-date, all but four of them relate to energy or metals and mining. On a par basis, 86% of defaults have been related to these sectors so far this year.4 And we think this is just the beginning.
We believe this will pose a problem for the index based products. Again, these sectors combined make up about 16-19% of the indexes, leaving notable exposure for the passive products tracking the indexes, such as the large index-based ETFs, JNK and HYG and their derivatives. This exposure that can’t be avoided as these products don’t base investment decisions on fundamentals, but rather primarily on what is held in the underlying index. And given that the energy and commodity sectors are such a big portion of the market, we don’t see the “diversification” benefit that many cite in index-based investing as posing much of a help.
Right now, investors in the high yield market have to walk a tight balance between opportunity and default risk. For the vast majority of the market, we see great value and believe that investors are being overcompensated for the risk they are taking on (see our piece, “Making Sense of Markets” for our further thoughts). Yet there are problem areas to be avoided. We believe this is the time in the cycle when the “one of everything” approach by the index-based, passive products won’t work; rather, investors need to be digging into the fundamentals behind their investments to selectively and deliberately choose where they want to put their investment dollars. We believe this plays right into the hands of active investors; we believe active management is essential in today’s high yield market as investors look to avoid certain sectors and embrace the value to be had in the vast majority of the rest of the high yield debt market.