· Low defaults. Moody’s Investor Service reported the 12-month trailing global default rate ended 2012 at 2.6%, as fewer-than-expected companies defaulted during the fourth quarter. On a dollar volume basis, the default rate finished the year at a subdued 1.7%. Moody’s forecast that defaults would likely remain low throughout 2013 and end the year at 3.0%, below the long-term historical average of 4.8%. In our view, current yield spreads compensate investors for the level of expected defaults [Figure 2]. Thanks to record-low interest rates, high-yield bond issuers have refinanced a substantial amount of debt and only a limited amount of bonds mature in 2013—a key factor in keeping defaults low.
· Good fundamentals. Aside from low defaults, credit quality metrics among high-yield bond issuers remain strong. Average debt burdens increased slightly over last half of 2012, but leverage remains low by historical comparison. Furthermore, cash on hand remains near record-high levels, and interest coverage ratios remain near recent peaks. In sum, although credit quality metrics peaked in the middle of last year, they remain supportive of current valuations and vastly different to pre-crisis levels when leverage was high and fundamentals were rapidly deteriorating. Fourth quarter 2012 earnings reporting season, which is underway, will provide additional clarity on corporate bond fundamentals.
Figure 2: High-Yield Valuations Remain Well-Removed From Pre-Financial Crisis Levels and Still Compensate Investors for Expected Defaults
The Moody's default rate represents the percentage of companies rated below investment-grade (Baa3) by Moody's, which have defaulted over the preceding 12 months. Default is defined as a failure to make an interest payment, repay principal at maturity, or debt exchanges where bondholders are forced to accept a reduced principal amount at maturity and terms of original debt are materially altered.
Nonetheless, lower high-yield bond yields suggest a closer look at bank loans is warranted. Should the upcoming battle in Washington over the debt limit turn ugly and risk a government shutdown, or should economic data show increasing odds of a recession, high-yield bond prices may weaken. Despite the factors supporting current high-yield bond valuations and yields, the lower absolute level of yield provides less protection against price declines in the event of a market downturn.
The recent decline in high-yield bond yields further narrowed a shrinking yield gap between high-yield bonds and bank loans [Figure 3]. The declining yield gap suggests that investors can obtain nearly the yield of high-yield bonds but with less price volatility. Bank loans have historically exhibited much less volatility during market downturns due to their seniority over high-yield bonds in the event of bankruptcy. The reward per unit of risk is increasingly pointing to bank loans, especially for more conservative investors. For more on bank loans please see our 11/27/12 Bond Market Perspectives: Banking on Bank Loans.
Figure 3: The Yield Disparity Between High-Yield Bonds and Bank Loans Continues to Narrow
Conclusion
The drop in the average yield of high-yield bonds below the psychologically important level of 6% must be taken with a grain of salt. The now-lower yield must be taken in the context of a low-yield world supported by the Fed’s accommodative monetary policy. Valuations are high across the bond market, as evidenced by record lows across most sectors—not just high-yield bonds. High-yield bond valuations are moderately expensive by historical norms but are supported but good credit quality metrics and low defaults. Should the debt limit not be resolved or the risk of a recession increase, high-yield bond prices may weaken. For this reason, bank loans become an increasingly attractive alternative as the yield disparity to high-yield bonds narrows and provide investors an alternative until the “high” gets back into “high-yield.”