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Fridson: How far out does high-yield bond market look in discounting default rates?

Churchill Downs announces $400M of eight-year notes for debt refi

Judge dismisses Marble Ridge claims over Neiman's MyTheresa transfer

Affinion receives consents for recap, covenant elimination

Revlon delays annual 10-K, details liquidity, ERP-related losses

Fridson: How far out does high-yield bond market look in discounting default rates?

Note: The following is a special monthly report from Marty Fridson. For his latest weekly column, please see “Industry Sharpe ratios,” published on July 30, 2013.

Relating pricing to default-rate expectations
Financial markets are generally regarded as forward-looking, as exemplified by the use of stock prices as a leading economic indicator. Such a characterization makes conceptual sense in the case of the high-yield risk premium, or spread-versus-Treasuries (SVT). Investors have the option of buying Treasury bonds, with no risk of loss from default (see note 1). Logically, they will buy high-yield bonds only if they offer enough additional yield to offset future default losses. (Default losses are defined as the speculative-grade default rate less recoveries on defaulted issues.)

In theory, the default rate expected by the market can be backed out of the SVT, as in this example based on June 30, 2013 data:

This calculation oversimplifies matters and overstates the market-expected default rate. Before agreeing to choose high-yield bonds over Treasuries, investors must be compensated not only for default risk, but also for the comparative illiquidity of high-yield bonds. This is evidenced by the excess of the average SVT for the period 1982-2012 (note 3) over the Moody’s mean annual default loss rate for the same period:

5.80% – 2.73% = 3.07%

High-yield strategists generally treat this difference as the illiquidity-premium component of the high-yield SVT. They subtract it from the option-adjusted spread (OAS), the most rigorous version of the SVT, to derive the pure default-risk premium. Users of this “breakeven” method calculate the market’s June 30, 2013 expected default rate as follows:

The practical significance of this result is that the 3.50% expected default rate exceeds the current consensus default rate forecast. Moody’s, for example, currently projects a U.S. default rate of only 2.40% over the next 12 months. Strategists deduce that high-yield bonds are undervalued because according to their pricing, the market expects a default rate about one percentage point higher than econometric default-rate models predict.

Why the preceding calculation is fallacious
Let us hasten to say that we strongly disagree with the just-described methodology on several grounds. To begin with, strategists always apply a 40% recovery rate when in fact the rate varies widely from year to year, as an inverse function of the default rate. More problematic is the fact that liquidity conditions vary widely from period to period, making it erroneous to apply a standard premium of 3.07% or thereabouts. By the logic of the breakeven method, there have been periods in which the high-yield market expected a negative default rate. For example:

This is not a unique result. According the breakeven model, there were 25 months between 1997 and 2012 in which the market expected a negative default rate. Given that a negative default rate is impossible, the most widely used method for backing out the expected default rate and valuing the high-yield market fails the test of internal consistency.

As discussed elsewhere, we believe the soundest method for deducing the market’s expected default rate utilizes the distress ratio, defined as the percentage of issues in the high-yield index characterized by an option-adjusted spread (OAS) of 1,000 bps or more, indicating a high probability of default (note 4). Furthermore, the best-supported method of determining the value of the high-yield market does not attempt to back out the market’s expected default rate and compare it to a default-rate forecast. Our own methodology instead employs a multiple regression model to explain the historical variance in OAS. This approach enables us to calculate, for a given month, a fair-value spread, given the level of total risk. (Total risk is not limited to default risk and does not incorporate a fixed – and therefore, at most times, inaccurate – illiquidity premium). Comparing our methodology’s fair-value spread to the actual spread determines whether high-yield bonds are rich, cheap, or fairly valued (note 5).

Why the market’s range of vision matters
Notwithstanding the inherent superiority of a method that does not indicate that the market frequently predicts a negative default rate, most strategists cling to the flawed breakeven model. Their fidelity to a discredited approach raises a problem that is of at least academic interest. Specifically, by comparing the market-implied default rate to a one-year default-rate forecast, the breakeven method implicitly assumes that the OAS reflects only defaults that are expected to occur within the next 12 months. Such an assumption is certainly open to question.

Consider this case:

At the beginning of Year 1 the consensus default rate forecast is 2% in Year 1 and 6% in Year 2. The high-yield index’s OAS is 547 bps. According to the breakeven method, the pure default risk premium is:

At first blush, the high-yield market appears greatly undervalued, as its OAS indicates an expected default rate of 4%, double the consensus of 2% in Year 1. Is it not possible, though, that the market is being a bit more farsighted and taking into account that the default rate is predicted to triple to 6% in Year 2?

What if the market is splitting the difference between the 2% Year 1 default rate and the 6% Year 2 default rate and discounting a 4% rate? In that case, the OAS of 547 bps is exactly in line with the default rate outlook. Rather than being grossly undervalued, high-yield bonds are fairly priced, according to this analysis. For steadfast proponents of the breakeven method, it matters a great deal whether the market sees beyond one year or ignores evidence that the default rate may be considerably higher or lower in the subsequent year. Indeed, it is conceivable that the market looks out to the third or fourth year or beyond.

The question we propose to answer: “How far out does the high-yield market look in discounting future default rates?”

To answer the question, we make an essential assumption that on average, the market accurately estimates future default rates for as far out as it can. Based on that assumption, we reason that the period (number of years) over which the market looks ahead at default rates is the period over which the cumulative default rate best explains (has the highest correlation with) the beginning-of-period OAS.

We proceed by regressing the Master II’s year-end OAS from 1996 to 2011 against the default rate in each corresponding, subsequent year. Then, we regress OAS against the cumulative default rate for the corresponding two subsequent years, for the corresponding three subsequent years, and so on up to 10 years. The default rate used in this analysis is the Moody’s speculative-grade, percentage-of-issuers series. (These are global statistics but U.S. issuers dominate the speculative-grade universe.)

In the chart below, the vertical scale (y-axis) indicates the percentage of OAS variance explained (R-squared) by the subsequent default rate. The horizontal scale (x-axis) shows the number of years over which the subsequent, cumulative default rate is measured. For each year we show both the R-squared for all years in our observation period and the R-squared excluding results related to year-end 2008 (the inordinately large OAS on that date, 1,812 bps, may produce an exaggeratedly high correlation).

If the R-squared for the two-year cumulative default rate were higher than the R-squared for the one-year default rate, it would imply that the market was looking out beyond one year and discounting default rates out to two years. We find, however, that the percentage of variance explained is substantially higher over a one-year horizon than over a two-year horizon (55.07% versus 31.89%, using the figures that exclude the 2008-related results, as detailed above). The R-squared trails off sharply in Years 3 and 4. We conclude that users of the breakeven method need not worry about their method, flawed as it is, being made worse as a consequence of the market discounting future defaults beyond one year.

Supplemental analysis
Our thinking about the main question of this report led us to run one additional test. We broke down the speculative-grade universe into its alphanumeric (Ba1, Ba2, etc.) components. Next, we calculated the monthly mean OAS for each alphanumeric category for the period 1988-2012. (Moody’s first applied its 1, 2, and 3 modifiers for the Caa category in 1998.) For each horizon from 1-10 years, we ran regressions to determine how much of the variance in OAS among the Master II’s equivalent alphanumeric categories (BB1, BB2, etc.) was explained by those categories’ cumulative default rates.

In the chart below, the y-axis indicates the percentage of variance in OAS among the alphanumeric rating categories that is explained by cumulative default rates. The x-axis shows every horizon from 1-10 years.

R-squared is very high (94.17% or above) in every horizon. There is a slight escalation from 99.16% in Year 1 to 99.98% in Year 2, followed by a monotonic decline through Year 10. These results suggest that the market looks out two years in differentiating the risk premiums on different gradations of speculative-grade debt. That is despite the fact that the previous chart indicates rather forcefully that the market does not look beyond one year in determining the risk premium on the high-yield category as a whole.

As for applications of this ancillary finding, portfolio managers can use it to assist judgments that at a point in time the differentiation in OAS among the rating categories is too great or too small. Suppose, for example, that with the year-ahead forecast of the default rate at 3%, the market seems to be rewarding investors too generously for shifting from B issues to Caa issues. Further suppose that the portfolio manager believes the default rate will escalate to 5% in months 12-24. Our finding would lend support to the view that the market is looking out beyond the first 12 months and that therefore the pickup from B to Caa is fair, rather than generous.

Concluding thoughts
One useful finding of this study is the very high explanatory power of future default rates with respect to the high-yield OAS, as illustrated in the first chart. To be sure, that explanatory power is with the power of hindsight. If we had a crystal ball to tell us the default rate for the next 12 months, we would incorporate it into our fair-value model. As it is, we must rely on explanatory variables that are known at the time of the valuation. The contemporary (trailing) default rate is known, but at least as far as OAS goes, has little explanatory power. By far the most powerful variable in our fair-value model is a measure of credit availability derived from the Federal Reserve’s quarterly survey of senior loan officers.

Martin Fridson, CFA
CEO, FridsonVision LLC

Research assistance by Xiaoyi Xu


1. Treating U.S. Treasury obligations as default-risk-free instruments was an analytical convention, rather than a literal reflection of reality, even before Standard & Poor’s downgraded the debt from AAA on Aug. 5, 2011. The AAA rating does not indicate total absence of default risk over an extended period, even though no corporate issuer has defaulted within one year of holding that rating.

2. This figure does not represent the yield on Treasuries of one particular maturity. The option-adjusted spread on the high-yield index is derived by spreading each of the index’s constituent issues against its corresponding point on the Treasury yield curve. We calculate the underlying Treasury yield by subtracting the index’s option-adjusted spread from its yield-to-worst. The resulting figure tends to correspond roughly to the five-year Treasury yield.

3. We calculate this historical figure as the yield-to-maturity difference between the BofA Merrill Lynch High Yield 100 Index and the five-year Treasury Index. The superior definition, referred to in note 2, the mean OAS on the High Yield Master II Index, is available only from Dec. 31, 1996 onward. From that date through the end of 2012, the rough-and-ready calculation based on the High Yield 100 exceeds the OAS calculation by 34 bps.

4. See “How to tell when distressed bonds are attractive” (Nov. 28, 2012).

5. See “Determining fair value for the high-yield market” (Nov. 13, 2012).

Churchill Downs announces $400M of eight-year notes for debt refi

Churchill Downs (Nasdaq: CHDN) is in the market with a $400 million offering of eight-year (non-call three) notes, sources said. An investor call for the J.P. Morgan–led deal is scheduled for today at 11 a.m. EDT.

Proceeds will be used to repay existing debt. Existing unsecured debt ratings are B+/Ba3. Additional bookrunners for the 144A-for-life offering are PNC, U.S. Bank, Fifth Third, and Wells Fargo.

Churchill Downs last accessed the bond markets in December 2017, placing $500 million of 4.75% notes due 2028. Trade data show the notes closed the session yesterday at 95.75, to yield 5.36%.

The issuer’s long-term debt also includes a $400 million B term loan due 2024 (L+200, 0% LIBOR floor).

The company in February reported fourth-quarter and full-year results, citing a 22% increase in net revenue for fourth-quarter 2018, at $219 million. Full-year revenue was roughly $1 billion, up 14% over the prior year.

Louisville, Ky.–based Churchill Downs operates as a racing, gaming, and online entertainment company in the U.S.

Judge dismisses Marble Ridge claims over Neiman's MyTheresa transfer

The judge overseeing a lawsuit against Neiman Marcus Group has dismissed claims made by distressed hedge fund Marble Ridge that the retailer’s transfer of its MyTheresa asset to a subsidiary outside of creditors’ reach violated the terms of its indenture.

Judge Tonya Parker cited a “lack of subject matter jurisdiction,” according to a court document filed in Dallas, siding with Neiman's argument that Marble Ridge lacked standing to assert their claim.

“[Marble Ridge] Master Fund is not a creditor of Neiman Marcus based on its alleged holdings of term loans because it is not a lender under Neiman Marcus’ Term Loan Agreement,” Neiman counsel Mike Lynn of Lynn Pinker Cox Hurst argued in the defendants plea to the jurisdiction in December.

To prove an action for fraudulent transfer, Master Fund must be a creditor, the defendants argued. “Marble Ridge Plaintiffs lack standing to bring the claims asserted in their original petition,” Lynn said.

The order dismisses all of Marble Ridge’s complaints without prejudice.

“From the beginning, we have said Marble Ridge’s lawsuit lacked merit. We are pleased that the Court has fully vindicated our position and dismissed all of Marble Ridge’s claims with prejudice,” Neiman Marcus said in an emailed statement to LCD.

The Dallas-based retailer is currently in talks with creditors on an out-of-court restructuring that would give the company a three-year runway on its term loans and unsecured notes to implement its turnaround plan. While the deal would return an equity stake in the luxury fashion brand MyTheresa, 50% would remain out of the reach of creditors in case of a default, Marble Ridge argued.

For further coverage of the proposed restructuring see “Marble Ridge says Neiman Marcus revamp a 'devil's bargain'," LCD News, March 4, 2018, and “Neiman Marcus restructuring sees MyTheresa stake for noteholders," LCD News, March 1, 2019.

The case is Marble Ridge Capital LP v. Neiman Marcus Group Inc., DC-18-18371, in the District Court of Dallas County, Texas. A hearing on Neiman Marcus Group's defamation case against Marble Ridge is still scheduled for 9 a.m. on March 21.

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LCD comps is an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.

Affinion receives consents for recap, covenant elimination

Apollo-controlled Affinion Group has met the required 98% participation threshold to proceed with its proposed recapitalization plan. In addition to reducing debt by $628 million and extending its maturity profile, the company also received consents to eliminate financial covenants under its indenture.

The restructuring proposal came after the marketing concern failed to make a $22.2 million interest payment due Feb. 19 on its first-lien term loan due May 10, 2022, entering instead into a forbearance agreement with its first-lien lenders through June 3.

If the transaction is not completed, Affinion has warned it could seek to restructure via Chapter 11, obtaining a $55 million debtor-in-possession term loan facility with HPS Investment Partners, Manchester Securities, and Zev Investments for this purpose.

The distressed exchange will swap about $700 million of principal of the company's 12.5%/pay-in-kind (PIK) 15.5% step-up notes due 2022, which were put in place as part of a 2017 restructuring, for equity in the company. Affinion also plans to issue $357 million of 18% PIK unsecured notes due 2024 (unrated) and use net proceeds of about $300 million to repay its full revolver borrowings of $108 million and pay down $153 million of the approximately $872 million outstanding on its first-lien term loan due 2022.

Pro forma for the repayment, $719 million of the term loan will remain outstanding, with the loan's maturity extended to 2024, from 2022. Additionally, as part of the transaction, the total commitment under the revolver will be reduced to $80 million, from $110 million, and the maturity extended to 2023, from 2022, according to S&P Global Ratings.

As of Dec. 31, Affinion had $84.7 million of cash and cash equivalents.

“We believe Affinion's decision to forgo its interest payment is strategic because it proposed a new recapitalization plan and negotiated with lenders to restructure the balance sheet, and not due to insufficient liquidity given cash on hand,” S&P credit analyst Elton Cerda said in a March 8 report.

Prior to the removal of financial covenants, the issuer was subject to a 6.75x senior secured leverage ratio governing the facility, scheduled to step down each quarter in 2019 to 6.38x, 6.25x, 6.00x, and 5.88x, respectively.

Affinion, a provider of loyalty and customer engagement solutions, placed the PIK toggle bonds in 2017 as part of a restructuring that swapped its existing unsecured notes in a deal said to be backstopped at the time by a significant portion of the company's existing senior unsecured lenders.

The loss of a key customer last year, however, is expected to result in a double-digit decline in revenue and EBITDA in 2019, according to a December report by S&P Global Ratings. S&P has since lowered its rating on Affinion, to SD, from CCC–, on account of the missed term loan payment. Moody’s lowered Affinion to Ca, from Caa3, and withdrew all ratings.

Revlon delays annual 10-K, details liquidity, ERP-related losses

Revlon, Inc. has delayed the filing of its annual 10-K report for the fiscal year ended Dec. 31, 2018, saying it has identified a material weakness in its internal financial reporting related to the implementation of its enterprise resource planning (ERP) system in the U.S.

In addition to the company’s dwindling liquidity position, service level disruptions at its Oxford, N.C. manufacturing facility following the February 2018 implementation of the new ERP system have been a key concern for investors in light of the impact on the company's ability to manufacture and fulfill shipments to U.S and international retail customers.

According to preliminary numbers released by Revlon, net sales fell 4.8% to $2.56 billion for the full-year 2018. The company said the performance reflects a net sales reduction of $64 million related to the previously referenced service level disruptions stemming from the ERP system implementation.

Operating losses widened to $85.2 million in 2018, from $23.8 million in 2017, again, driven primarily by lower net sales and costs associated with remediating the SAP disruption at its North Carolina manufacturing facility, as well as a $20.1 million loss related to reacquiring certain iconic Elizabeth Arden trademark rights.

Revlon's net loss came in at $294 million for 2018, compared to a net loss of $183.2 million last year.

The unaudited results showed adjusted EBITDA of $237.9 million for the year, compared to $257.3 million in 2017.

Revlon said the assessment of its internal controls over financial reporting for 2018 is not expected to result in any changes to the disclosed financial results.

In terms of liquidity, the company’s liquidity position had fallen to $118 million as of Feb. 28, from $160 million at year-end 2018. Its current liquidity consists of $75 million of unrestricted cash and cash equivalents, as well as approximately $50 million in available borrowing capacity under its revolving credit facility, less float of $7 million. As of Dec. 31, Revlon had $87.3 million of unrestricted cash and cash equivalents, as well as $96.4 million in available borrowing capacity under the revolving credit facility (which had $335 million drawn at the time), less float of $23.4 million.

Revlon bonds were in the red ahead of the filing, but losses deepened post the aftermarket disclosure. Revlon Consumer Products 5.75% notes due 2021 (CCC/Caa3) traded in clips at 84, down roughly 2.5 points on the day. The notes started the year at 75, before trading up alongside the broad-market rally to peak levels this month on either side of 87.

Revlon earlier this month entered into an amendment to its asset-based revolving credit agreement to extend the maturity date applicable to the $41.5 million senior secured FILO tranche to April 2020, from April 2019. The fully-drawn FILO tranche was placed in April last year to provide for the additional first-in/last-out tranche commitment under its ABL revolver. See “Revlon TL gains on new FILO "liquidity comfort", LCD News, April 20, 2018.

Revlon manufactures, markets, distributes, and sells beauty and personal care products. Corporate issuer ratings are CCC+/Caa1.

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LCD comps is an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.