This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to S&P Global Market Intelligence.
Management consultant Peter Drucker reportedly said, "If you can't measure it, you can't improve it." Curiously, that bit of wisdom does not appear in a list of 73 quote-worthy Drucker quotes. Unfazed, the author of one think piece calls the maxim one of the two most important quotes in business management.
Be that as it may, high-yield managers may want to take the advice about measurement to heart. They have a strong motive for improving their credit analysis, even if it is already quite good. Prospective clients may also be interested in measuring the credit skills of managers who are competing for their high-yield mandates. To both managers and clients, default rates of managed portfolios may appear to be a useful metric for the purpose.
In the following discussion we first address the question of whether a manager's default rate is a valid measure of the effectiveness of its credit analysis. Then, for the benefit of those who conclude that managers' default rates are indeed worth measuring, we lay out the criteria for matching a manager's default rate to a suitable benchmark rate. Next, we use data generated by S&P Global Ratings to calculate an appropriate benchmark default rate for managers charged with investing specifically in bonds (as opposed to some mixture of bonds and loans). Finally, we point out the present market's optimistic — perhaps unrealistically so — expectation regarding the default rate for the next 12 months.
Do default rates adequately measure managers' credit skills?
No buy-side analyst relishes the prospect of placing an internal BUY recommendation on a bond, based on a judgment that its recent decline represents an overreaction to a temporary earnings setback, only to see the issuer deteriorate further and finally default. From the standpoint of the investment team as a whole, however, it is by no means clear that a 0% default rate is the optimal target.
After all, the foundational "case for high-yield bonds" was that, yes, a small percentage of them default, but the extra yield that compensates investors for that risk produces a higher net return than investment-grade issues generate. Avoiding one default might come at the cost of missing 10 outstanding turnarounds, the returns on which could far exceed the loss on a single crash-and-burn scenario. Skillful credit analysis includes identifying situations with large upside. A 0% default rate plus an inferior risk-adjusted return does not add up to bonus-worthy portfolio performance.
Another drawback to measuring credit skills by an organization's default rate is the investment team's ability to game the system. This is a vulnerability of measurement schemes in general. In the case of organizational default rates, a manager can dump a bond that is almost certainly headed for Chapter 11, accepting a lowball bid from a vulture fund. That ploy hurts the portfolio's performance solely for the sake of keeping a default off the scoreboard. When that happens, the measurement system ceases to be a passive evaluator of the manager's actions, becoming instead an active driver of those actions.
Notwithstanding these drawbacks, we see some merit in monitoring an investment team's default rate, with one proviso: Instead of setting the objective at 0%, the measurement system should compare the organization's default rate with the overall high-yield default rate. In a high-default-rate period, an above-average default rate may warn clients that the investment team has lost control and that strong remedial measures are required. Even in a period of a moderate default rate, an organizational default rate higher than the high-yield universe is experiencing can indicate to the management organization that too many of its high-risk plays are going the wrong way. The time may have come to recalibrate the team's risk-reward tradeoff.
A proper match
On Jan. 8, S&P Global Ratings published a 6.6% U.S. speculative-grade default rate, cautioning that the figure was preliminary and subject to change. That rate represents a suitable benchmark for managers operating under bond-plus-loan mandates, but what about those who concentrate on bonds and are benchmarked to the ICE BofA U.S. High Yield Index? Their credit skills could be mismeasured by rate that includes defaults by such prominent names as Anchor Glass Container Corp., Briggs & Stratton Corp., California Pizza Kitchen Inc., Jo-Ann Stores Holdings Inc., Libbey Inc., Ruby Tuesday Inc., Serta Simmons Bedding LLC and Steak 'n Shake Inc., none of which were represented in the ICE BofA U.S. High Yield Index on Jan. 1, 2020. This is not to mention several defaults by loan-only issuers identified only as "Confidential" in Ratings' Jan. 8 report. To tailor the default rate to bond-focused managers who are benchmarked to the ICE BofA U.S. High Yield Index, we limited our numerator (number of defaults) to issuers represented in that index.
We mentioned Jan. 1, 2020, in the preceding paragraph because only defaults by issuers represented in the ICE BofA U.S. High Yield Index on that date are included in our calculation of the trailing-12-months rate through Dec. 31. Therefore, for the sake of illustration, if a bond first enters the index as a fallen angel in March 2021 and defaults in November, our methodology would count that default in the trailing-12-months rate through February 2022, but not through December 2021. Our treatment is similar for "NCAA" (no coupon at all) bonds. If an issuer not previously represented in the index issued a qualifying bond in May and failed to make its first scheduled semiannual interest payment in November, the issuer would not show up in our default statistics until we published the rate for the 12 months ending the following April. Inclusion in the index as of the base date is one of several factors that users of the rate we report below must take into account in calculating a comparable rate on the portfolio they are evaluating. Here are the other factors:
Events of default include missed interest payments, missed principal payments, Chapter 11 or other bankruptcy filings, distressed exchanges (as determined by S&P Global Ratings), and out-of-court restructurings. Let us hope that the former canard that the rating agencies' default statistics omit distressed exchanges has long since been laid to rest. Note that as a result of distressed exchanges, some defaulting issuers with ratings higher than D from S&P Global Ratings continued to be represented in the index (which excludes issues that are not current on their scheduled payments) at year-end 2020.
The denominator (number of issuers) in our calculation is based on tickers assigned to bonds in the ICE BofA U.S. High Yield Index. This means that a holding company and one or more related operating companies or finance subsidiaries may all be counted as a single issuer for our purposes. Comparisons of portfolios' default rates with our benchmark rate should be calculated on the same basis. Note that a default can occur on a loan of one of these affiliated entities and be counted in Ratings' total, but not affect our statistics, even though another, non-defaulting affiliate is represented in the ICE BofA U.S. High Yield Index.
Our calculations count only one default per issuer, even though in a number of cases S&P Global Ratings recorded more than one event of default for the issuer during 2020. An issuer may default more than once in the space of a year if a distressed exchange aimed at strengthening the issuer's balance sheet proves insufficient to restore its financial health. As an example, Ratings listed Guitar Center Inc. as a default on May 11, 2020, in connection with a distressed exchange and again on Nov. 18, 2020, when the company missed a coupon.
Our 2020 high-yield bond default rate
The 146 defaults tabulated by Ratings in 2020, including defaults by loan-only issuers and repeat defaults within the year, yielded a numerator of 52 defaults that met our above-listed criteria. That figure compared with a denominator of 834 ticker-defined issuers, as of Jan. 1, 2020. The resulting U.S. high-yield bond default rate was 6.2%.
In 2020, at least, our U.S. speculative-grade bond default rate was not dramatically different from the 6.6% bonds-and-loans rate tentatively reported by Ratings. The gap could be wider in other years, particularly in peak default rate years, when the rate typically reaches double digits. As suggested above, high-yield managers and clients should consider performance vis-à-vis our benchmark along with total return performance versus the ICE BofA U.S. High Yield Index. The ultimate investment objective is not to minimize the default rate but rather to maximize the risk-adjusted return. Highest accolades should be reserved for managers who consistently both undershoot the default rate benchmark and overshoot the total return benchmark.
Market-implied default rate forecast ex-Energy looks extremely optimistic
Looking ahead, our analysis finds that the U.S. high-yield market is implicitly forecasting a non-Energy default rate equivalent to the lowest annual rate of the modern default rate era. In the wake of the Jan. 8 report that employment fell by 140,000 in December, the first drop in eight months, investors may want to consider whether the market is unrealistically optimistic.
As detailed in "How to tell when distressed bonds are attractive," the U.S. distress ratio, defined as the percentage of issues in the ICE BofAML U.S. High Yield Index quoted at distressed levels (OAS of 1,000 bps or more), can be used to derive the market's implicit forecast of the speculative-grade default rate. The distressed default rate — conceptually, the percentage of distressed issuers that default within one year — declines as the distress ratio increases. Multiplying the distress ratio by the distressed default rate gives us the market's expected 12-month default rate.
Using the updated methodology detailed in Estimating the market-implied default rate, we begin by calculating a Jan. 8 distress ratio of 4.88% for the ICE BofA U.S. High Yield Index. The distressed default ratio is (-0.3031 x 4.88%) + 35.50% = 34.02%. Multiplying by 4.88% tells us that the high-yield market is forecasting a default rate of just 1.7% for the next 12 months. That compares with an implied Moody's forecast for U.S. speculative-grade bonds of 4.9%. We derive this estimate by multiplying Moody's U.S. most recent bonds-plus-loans forecast of 7.7% by the 0.64 ratio of the rating agency's global bonds-only to global bonds-plus-loans forecasts. Based on historical experience, we classify a divergence of one percentage point between the market-implied and Moody’s forecast as an extreme. The current gap of 3.2 percentage thus qualifies as a triple extreme.
That is not the whole story, though. The troubled Energy sector currently accounts for one-sixth (16.6%) of the ICE BofA U.S. High Yield Index's total issues but one-half (50.5%) of its distressed issues. Energy's overrepresentation in the distressed universe means that the market expects a 5.2% default rate in that sector over the next 12 months. The market-implied forecast for the non-Energy sector is 1.0%.
Let's put that 1.0% forecast into historical perspective. The modern era for default rates can be said to have begun in 1989, the first year in which the majority of speculative-grade issuers was rated below Ba by Moody's. In earlier years, the ranks of speculative-grade companies were dominated by less default-prone fallen angels and new issues rated just below investment-grade. In the period from 1989 onward, the lowest default rate reported by Moody's for any 12-month span was 1.04%, in the periods ending Nov. 30, 2007, and Dec. 31, 2007. The high-yield market's current 12-month forecast is slightly lower, at 1.00%.
Investors can judge for themselves whether the coming 12 months promise to be the most benign in the past three decades for speculative-grade credit performance, even taking into account extraordinary efforts on behalf of the U.S. economy in the form of both highly accommodative Fed monetary policy and Congress' recently enacted second stimulus package.
Research assistance by Lu Jiang and Zhiyuan Mei.
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