Vimal Gore is BT Investment Management’s Head of Income and Fixed Interest. In his latest monthly newsletter he spent a good part of it discussing the high yield market. The high yield market comprises debt securities which are sub-investment grade. That is, they have credit ratings below BBB- (S&P) or below Baa2 (Moody’s). Naturally they have a higher yield than investment-grade securities and this is why some investors are attracted to them.
The higher yield comes at a price, however and on average, high yield securities are much more likely to default. Gore quotes an S&P observation about companies with debt rated B- or lower; these companies “are on average ten times more likely” to default than companies rated B through to BB+.
The difference between the benchmark yield and the yield on a particular security is known as the spread. In the case of corporate bonds this difference is often referred to as a credit spread. Gore explained the existence of the spread as a reward for the additional risk pointed an investor takes on. “Credit spreads are the portion of bond yields that compensates the investor for the default and volatility risk they are taking when buying the bond.”
So what minimum spread which makes up for this risk of default? According to Gore, in the U.S. it should be around 3%. He explained his calculation in the following manner. “The long term average default rate for US high yield is around 5%, and the average recovery rate achieved by investors is around 40%. This translates to expected losses…of 3%, or 300bps.”
So on average, across many different issuers and over various time periods, a diversified portfolio of high yield bonds will suffer losses equal to around 3% of the portfolio per annum. (Note to readers: “events” are often bunched in particular years with no events in others. Averages tend to disguise this.)