Analysis
By Alexia Latorre, analyst-manager, High Yield specialist at Lazard Frères Gestion
The risk of non-repayment is inherent in High Yield bonds, but this risk is often overestimated. The last 12 months are a perfect demonstration of this. Despite an unprecedented crisis, default rates have only risen by a moderate amount. They are now expected to drop.
This is the main fear among investors in the High Yield segment: not being repaid if the issuer becomes insolvent. However, this happens very rarely. Between 2012 and 2019, an average of only 3 or 4 defaults per year were recorded on High Yield stocks denominated in euros. Moreover, these were often only partial defaults: again, between 2012 and 2019, the average recovery rate was between 35% and 55% depending on the seniority of the bonds.
Having said that, the risk is not zero, which is why returns are higher in this market segment. A premium (credit spread) is applied to offset the risk linked to the potential losses incurred by investors in the event of default. Historically, the market has demanded a risk premium of around 250 basis points (2.5%) over the rate that would have been needed to cover actual losses. These are therefore more than compensated for by the spreads offered by issuers.
2020 – far less disastrous than expected
The health crisis in 2020 triggered an unprecedented recession. It is not surprising, therefore, that default rates increased in this environment. Nevertheless, the increase was far less than expected, thanks to the support measures introduced by governments (furlough schemes, tax deferrals, guaranteed loans) that have ensured a good level of liquidity for businesses. On the other hand, the bond market has continued to function, guaranteeing access to funding for companies.
During 2020, 12 issuers defaulted in the euro-denominated High Yield bond segment. At the end of February 2021, one year after the crisis began, the default rate over the previous 12 months was 4.7% on the European High Yield segment according to Moody’s. This number is well below that posted in 2009 after the subprime crisis (11.3%).
Note that of these companies, only two were not rated CCC one year previously. The companies that did not survive the health crisis were therefore already in a very fragile situation before the crisis. Moreover, recovery rates[1] have been particularly high: JP Morgan calculates an average recovery rate of 60% over the last 12 months[1]. Losses linked to defaults were therefore lower than those observed during the European sovereign debt crisis in 2012. At that time, the default rate did not exceed 3.6% but the recovery rate was lower.
2021: returning to levels below the historical average
In 2021, the recovery in growth should help to gradually bring down default rates. Moody’s anticipates a return to 2.5% by the end of the year, and even 2% in an optimistic scenario. It was 1.5% in February 2020, just before the health crisis hit, and 2.8% on average over the last 15 years.
Likewise, while the number of “fallen angels”[2] in 2020 was very high, the trend should now begin to stabilise and even turn around in 2021. We have already seen two “rising stars”[2] since the beginning of the year (Stellantis and Smurfit Kappa).
In summary, default rates should not be investors’ main concern in the coming months. In this context, the High Yield universe, by virtue of its low duration (3 to 4 years) and its high credit spreads, offers an attractive alternative in the bond segment.
[1] Recovery rate: percentage of the loan repaid despite a default event. A recovery rate of 60% means that defaulting issuers have been able to repay 60% of their loan, but were not able to repay the remaining 40% (partial default).
[2] Fallen angel: a company that was previously rated as Investment Grade by rating agencies that joins the High Yield universe | Rising star: a company previously rated as High Yield that joins the Investment Grade universe.
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Source : Lazard Frères Gestion
Article written on 22 March 2021.
The information provided is not intended to constitute investment advice and is intended for information purposes only. The data used in this document is used in good faith, but no guarantee can be given as to its accuracy. All data contained in this document, unless otherwise indicated, comes from Lazard. Past performance is not a reliable indicator of future performance.
Specific risks related to the High Yield segment: risk of capital loss, credit risk, interest rate risk, risk linked to derivative financial instruments, counterparty risk, risk linked to emerging markets, risk linked to securitisation assets, equity risk. There is also a risk associated with discretionary management in connection with the management of funds invested in the high yield segment.
This document is the intellectual property of Lazard Frères Gestion SAS. LAZARD FRERES GESTION – a simplified joint stock company with share capital of €14,487,500 – Paris Trade and Companies Registry No. 352 213 599. 25, RUE DE COURCELLES – 75008 PARIS, FRANCE
