Executive Summary
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The benefit to corporate bond investors of staying a step ahead of the credit cycle has stimulated interest in models for forecasting one of the cycle’s best markers, the default rate.
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A market-based forecasting model can complement actuarial and econometric models, which have inherent limitations.
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This article describes a market-based default-rate forecasting model, based on the distribution of outstanding high-yield bonds between the distressed and non-distressed categories, and the respective, historical default rates of those categories.
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The actual default rate tracks the market-based model’s year-ahead forecast fairly closely, although the forecast can overshoot under extreme market conditions.
The Nature and Importance of the Credit Cycle
Cycles play a major role in analysis aimed at achieving superior investment returns. Stock market participants base their valuations on corporate earnings, which fluctuate with the business cycle. The interest rate cycle strongly influences the performance of high-quality fixed-income assets, such as government bonds and mortgage-backed securities. Similarly, investors in corporate bonds, for which the risk of default is a material factor, can benefit from anticipating turns in the credit cycle.
At the beginning of the credit cycle, lenders perceive the risk of default to be low. They gladly extend loans even to low-quality borrowers, and accept small risk premiums (measured by yield differentials over risk-free rates). Inevitably, some borrowers incur more debt than they are able to support when the business cycle turns down. They consequently default on their obligations, which causes lenders to turn more conservative in their credit extension policies. As it becomes more difficult to borrow, other borrowers fail as a result of being unable to refinance their maturing debts. Finally, as the default wave subsides, lenders regain confidence and a new cycle begins.
The link between the comparative liberality of credit extension risk and premiums on debt is illustrated in Figure 1. In a quarterly survey conducted by the Federal Reserve, senior loans officers of major money center banks indicate whether they are currently raising or lowering the quality standards that corporate borrowers must satisfy to obtain loans. As banks make it harder to qualify for loans, the average risk premium rises in the investment grade corporate bond market.
Risk premiums, in turn, are closely connected with default rates. Figure 2 documents this linkage over the past two US credit cycles. The trailing 12-months default rate on speculative grade issuers reached cyclical highs in June 1991, January 2002 and November 2009. Corresponding to these peaks were the cyclical maximum points of the option-adjusted spread on the Merrill Lynch High Yield Master II Index, in January 1991, June 2002 and December 2008.
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