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Could Junk Bond Defaults Reach 20%?

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As the economy weakens, a predictable result is an increase in corporate defaults. In the early 1990s, the default rate on high-yield bonds peaked at 12+% (note some define the universe differently and come up with somewhat lower figures)

The most recent Standard & Poor’s forecast, while noting a marked deterioration in the economy and revising up its expected level of defaults accordingly, still forecasts that defaults over the next year will be considerably lower than the worst periods in the early 1990s recession and the dot-bomb era. However, in part that is because they are forecasting only as far out as full year 2009. From Research Recap:

Standard & Poor’s expects the rate of default in the U.S. speculative-grade segment to increase materially in the next 12 months, reaching 7.6% by September 2009, the highest level in nearly six years. Under a “pessimistic scenario,” the rate could go as high as 9.6%….

The pessimistic scenario yields a mean default rate of 9.6%, more than double the long-term average of 4.4% but still below the peaks of 10.8% in the 2001-2002 recession and 12.5% in the 1991-1992 recession. The optimistic scenario yields an average default rate of 6.1%. In the next 12 months.

But Accrued Interest, in “20% high-yield defaults? Don’t underestimate the power of the autos!” argues that Motown defauls could swamp forecasts:

On Monday the yield on the Merrill Lynch High Yield Master index reached a shocking 19.6%….. In short, if we’re getting 20% yield, could we wind up suffering 20% losses in defaults?

According to Moody’s, the largest default rate in history was 15% in 1933. In the post Depression era, there have been three years which produced double-digit default rates: 1990 (10.1%), 1991 (10.4%) and 2001 (10.6%). The average recovery rate (i.e., the amount the bond is worth immediately after default) is 32% for the three peak default years. So if a portfolio suffers 10% in defaults with 30% in recovery, it has actually suffered 7% in total credit losses.

That history would seem to favor high-yield….But risks remain. First, the proximate cause of most corporate bankruptcies is either an inability to roll over debts or a demand by creditors for collateral which the company cannot obtain.

Right now roll-over risk in high-yield is higher than any time since at least the early 90′s. Junk-rated companies can obtain funding through one of two routes, either bank loans or the public bond market. But neither of those are open to lower-quality borrowers right now. There have not been any new high-yield issues for the entire month of October. And banks remain highly unwilling to lend to anyone, much less to high-credit risk firms.

Should the credit markets thaw somewhat in the near term, new deals may be possible. But even if that happens, how many companies will be able to operate where the cost of debt is 20%?…

Then there is the 900-pound gorilla in the junk bond market: the autos. Ford and General Motors alone make up about 7% of the high-yield index. Recent stories in the media suggest that GM will need a loan from the government to complete a merger with Chrysler, and even then there are no assurances that the companies significant problems can be solved….

If high-yield defaults follow the “normal” recessionary pattern of about 10% defaults, but GM and Ford default as well, that would bring total defaults to about 17%, disturbingly close to the 19.6% yield on the index currently.

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7 comments

  1. evilHenryPaulson

    Another side of this story would be corporate earnings.

    If you look at the S&P500 going from annualized $96 operating EPS at peak, and facing what will be a very possible $60 for calendar 2009 (I would argue its beyond likely)

    I realize that financials have gone from 8 to 46% of those earnings inside of the last 20 years, but I think we'll see business earnings fall broadly. There won't be $800mn in quarterly HELOC withdrawals again any time soon. Wait for January until many realize how badly their business conditions are.

    Autos are a very important, but I worry about retail and general small business. Great post up on CalculatedRisk connecting unemployment and CRE vacancy rates — look for that vacancy rate to hit 20% if U3 goes to 8%

  2. Anonymous

    Not really knowing the details of CDS, could it reach 220%????
    No, really, I’m serious. And anybody who answers – do you really know?

  3. fresno dan

    Not knowing the details of how CDS’s affect bonds, could it reach 220%???
    Really, I am seriously asking the question. And anyone who answers – are you really sure?

  4. Ryan Barnes

    Nobody can know for sure what the CDS liabilities are for a particular “credit event”, but these represent a bigger risk to the system than and junk bonds themselves. Look at how much bigger the notional value of Lehman CDSs were; $360B net, ten times the largest market cap LEH ever got.

    EpiphanyOne

  5. FairEconomist

    Given the magnitude of the event we’re looking at, passing the 90′s peak seems inevitable. I expect to pass the 1933 peak, because there’s been much more junk lending in the past 20 years. Although I don’t expect the downturn to be as bad as the Great Depression, I think higher credit risk in junk bonds will produce an even higher default rate. Certainly the market prediction of 15% default rates or so is very reasonable.

  6. Anonymous

    The traditional 30% recovery rate cited by Accrued Interest probably won’t apply this time, because of all the covenant-lite debt this time around. Rather than being forced into bankruptcy workouts earlier in order to ensure at least some recovery for creditors, companies will keep going until the last possible moment and then abruptly go bust with nothing left to recover.

    Then again, that might be too pessimistic. Maybe only investment-grade debt was covenant-lite, with stricter standards for junk? How loose did things get in the go-go years?

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