Putting Spiking Default Rates Into Perspective

October 17, 2019

Source: J.P. Morgan Source: J.P. Morgan

U.S. High Yield (USHY) issuers continue to climb the market’s wall of worry. Year to date (YTD), the high yield market has performed well and is up over 10%, as measured by the J.P. Morgan Domestic High Yield Index. The highest-quality high yield bonds are leading returns, with BB-rated bonds up over 12%. Interestingly, the lowest-rated bonds are the biggest laggards in the index, with CCCs only up about 6.5% YTD. In a year where high yield indices are up double digits through the first three quarters, one would think that the riskiest issuers would be contributing the most to the solid returns.

Over the course of 2019, however, the bottom of the market has been slowly deteriorating. This week’s chart demonstrates that defaults have increased and the percentage of the high yield market that is trading distressed has also grown. Historically, an increase in default rates and credit spreads has not been a strong predictor of future economic slowdowns. Rather, a Goldman Sachs Credit Strategy Research report shows that while default rates are not a great predictor of a recession, they can help frame where the market and credit risks are at the moment. Therefore, the spike in defaults that we’ve seen is more likely to substantiate the deteriorating credit and economic environment today, but not necessarily indicate that it will continue to get worse.

With that said, the trend could continue and any one of the many concerns in the market today could shock the system into a recession. Concerns stemming from trade wars, impeachment inquiries, unrest related to the Middle East and its corresponding oil supply, and other geopolitical issues around the world have led to slowing economic growth. A default rate of 2.5% is still below the long-term historical average of closer to 3% for the J.P. Morgan Domestic High Yield Index. For perspective, it’s even more informative to compare the current default rate to historical recessions, when defaults spiked to about 10-15% of the index.

Key Takeaway

It’s clear that we are not currently in a recession and we would need to see a larger shock to the economy and default rates in order to reach that point. There are still plenty of macroeconomic and political risks out there that could be the catalysts. Fund managers are keenly aware of these risks and are tasked with finding the best places to invest every day. Perhaps the plethora of potential tail risks has led to an up-in-quality bias for high yield fund managers this year, and thus, the stronger returns for BB versus CCC-rated bonds. Historically, I’ve preferred, and continue to find value in, the up-in-quality high yield issuers.

Tags: U.S. High Yield | U.S. High Yield index | Junk bonds | Credit risk

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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