by Jeff Skoglund, Director of Global Credit Research, AllianceBernstein
High-yield bond defaults are historically low today, even for troubled companies. Despite the worries we hear in some corners about looming high-yield defaults, we think default rates will stay low for at least the next few years.
In the wake of the 2008 financial meltdown, US companies did the responsible thing and got leaner, reducing head count and overhead costs aggressively. When the recovery gained traction, they held the line on expenses—and profit margins are at historic highs today. Debt burdens are lower, too, courtesy of strong operating cash flows, restrained investment spending and debt refinancing at lower rates with longer maturities.
These actions have kept default rates low; here’s why we expect them to stay low ahead.
A slower-growth economy should continue to bode well for high-yield companies. Post-recession growth has been slower than usual in this recovery. This has actually been a very favorable environment for companies because it has kept interest rates low and inflation pressures—especially labor—subdued.
In this tepid recovery, management teams have faced unknowns ranging from Europe’s downturn to US elections, and tax and other fiscal uncertainty. In this environment, businesses have been anything but reckless in spending capital. Pursuit of growth and market share has generally taken a back seat to financial prudence. Higher-risk corporate mergers and acquisitions (M&A), including private-equity transactions, have increased in the first two months of 2013, but this sort of activity has been remarkably low for the last four years. As a representative example, M&A accounted for only 16.5% of high-yield issuance in 2012.
A refinancing wave has reduced companies’ near-term debt maturity requirements. Big bond payments or bank loans that come due at a bad time can lead to company defaults. Today, though, almost all high-yield companies have taken advantage of strong investor demand for high-yield debt and have refinanced their high-coupon, near-term debt with low-coupon, longer-maturity debt. So, there aren’t a lot of big bond payments or bank loans coming due anytime soon. US corporations issued an all-time record $368 billion of high-yield debt in the last year, but over 60% was for debt refinancing purposes.
None of this means we won’t see defaults ahead—of course we will. But we think the market is well aware of the potential defaults over the next three years. These stem from 2006–2007 leveraged buyouts, with companies piling on debt only to stumble into a worst-case scenario: a bad economy, bad earnings and thin cash flows. Some went bankrupt; others are still limping along and are widely expected to restructure at some point in the next few years. As a result, their bond prices today are deeply discounted, so they represent much more limited risk to high-yield investors.
We expect the overwhelming majority of defaults to come from the lowest-quality credits in the high-yield market—those rated CCC or lower by the major ratings agencies. In fact, roughly 50% of new-issue CCC bonds default within the first five years of issuance. Our research indicates that over the course of a credit cycle, investors are not adequately compensated for “stretching” for the additional yield offered by these bonds. This is particularly true at the present time.
Our bottom-line assessment?
As long as the economy avoids recession, we expect the next few years to be favorable for high-yield debt. Default rates are tracking at about 1.3% annually. Our analysis suggests that defaults could increase modestly to about 2.5% over the next few years. That’s well below the 4.2% long-term average and the peak default rate of 10.3% in 2009.
That would be far from a default wave. More like a ripple.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.
Jeff Skoglund is Director of Global Credit Research for Fixed Income at AllianceBernstein.
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