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High-yield investors could get burned soon [ClearOnMoney]
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High-yield investors could get burned soon

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Commentary

High-yield investors could get burned soon

28 Nov 2011 by Jim Fickett.

Today Fitch, the ratings agency, released a report entitled Fitch U.S. High Yield Default Insight (free registration required). This report covers the whole US junk bond market but, in order to illustrate a common underestimation of cyclical risk, I will concentrate on bonds rated CCC and lower.

You might think bonds with such low ratings would be rare, but in fact the fraction of new issuance rated CCC or lower has risen steadily during the recovery, from 7% in 2009 to 17% so far in 2011, and such bonds currently constitute 19% of the US market.

It seems natural, at least to the unwary, to evaluate future junk bond risk by looking at recent default rates. Fitch estimates the default rate on CCC and lower bonds during 2011 will be about 5%. If we assume a 50% recovery rate, that is only a 2.5% loss, easily covered by current double-digit yields. Probably many people think this way, helping to explain high-flying demand for the junkiest of junk.

However Fitch shows that CCC or lower bonds exhibit huge cyclicality, with the default rate varying from single digits in good times to over 40% in downturns. So the default rate in the recent past is not a good guide to the default rate going forward, especially if problems in Europe lead the world back into recession. And of course the bond prices fluctuate enormously as perceptions of default risk rise and fall.

Prices of CCC or lower bonds have been dropping this year – the fraction priced at 80% of par or lower has risen from 15% to 25%. That is a warning. Frankly, I think anyone who owns junk bonds on the eve of what may be another global financial crisis is nuts.