With near zero returns for prime sovereign debt, wealth managers and fixed income managers have been pouring money into high yield corporate bonds for more than a year in a search for better rewards.
Of course, the chances of a corporate – even an investment grade corporate – defaulting, are vastly higher than the chance that the US or the UK would find themselves unable to pay the interest on their bonds. After all, sovereigns can always simply print the money they need. (That makes going to the market for future cash handouts an interesting prospect, but so far the market has been pretty tolerant of Quantitative Easing).
However, to date the high yield corporate bond segment has been very well behaved, with minimal delinquencies, and investors have been well rewarded for their seemingly insatiable appetite for this sector. In its latest report (PDF - registration required) on the high yield corporate bond market, the ratings agency Fitch points out that US high yield bond defaults were running well below average through the third quarter of 2010. There were just eight defaults which affected a total of $2.5 billion in bonds.
This was somewhat higher than the second quarter, which saw just three defaults, but the market still expects high yield defaults to amount to no more than 1% of issuers for the full year 2010 – one of the lowest levels on record, according to Fitch.
If this is how things stand at the year end, it would leave bond holders feeling very comfortable and enjoying solid premium returns over government bonds even allowing for the default rate. Bond holders will also draw comfort from the fact that when corporates did default in 2010, they did so with far less money outstanding on average than was the case for defaults in 2009. In 2009 when a corporate went down it did so with some $786 million outstanding in bonds. In 2010 this figure was just $265 million, a three-fold improvement.
Further analysis by Fitch suggests that part of the reason for the excellent low default rate is that some rather large corporates are included in the high yield sector. A lower rate of default among these larger borrowers has the effect of squashing the overall average amount outstanding at default down, since, by definition, the companies failing are smaller issuers. The upshot of Fitch’s analysis is that the ratings agency expects the actual default rate, in terms of number of issuers, to be higher than 1%.
It expects to see about 2% to 2.5% of issuers defaulting in the high yield space, but these should be smaller borrowers so their effect on the par default rate will not be such as to disturb that forecast 1% figure.
What all this speaks to is the need for investors to ensure that they have a good spread of corporate bonds in their portfolio, since trying to predict which particular company will default is exceedingly difficult.
From the perspective of corporates still planning to come to the market for cash, the low default rate is very good news, since it should whet investor appetite for still more high yield fare. With companies able to tap the market for cash almost at will, the prospects for enhanced corporate returns look brighter for the year ahead. Of course having the cash is one thing, putting it to work successfully in an opaque and uncertain global market is something else entirely.
Further reading on raising capital and the capital markets:
- Trading in Corporate Bonds: Why and How - a checklist.
- The Role of Institutional Investors in Corporate Financing, by Hao Jiang
- Issuing Corporate Debt, by Steven Lowe
- Using Securitization as a Corporate Funding Tool, by Frank J. Fabozzi
Tags: banking , corporate bonds , credit rating agencies , default rate , Fitch , investment grade bonds , par default rate