Company defaults are one of the main discussion topics in High Yield meetings and one that causes a high level of anxiety to clients, especially in an environment of widening spreads. Let’s dissect the current and expected default experience within the European and US High Yield markets.
In the European High Yield market, default rates have been consistently low for a number of years, and at 0.69% for the last twelve months as at the end of September 2015 (chart 1). This is due to a number of factors, namely the introduction of the Quantitative Easing program in the Eurozone at the start of 2015; the economic improvement in the region, core and periphery; and finally the extremely low energy sector exposure, which at the end of December 2015 was approximately 1.2% of the BofA Merrill Lynch Euro Developed Markets Non-Financial High Yield constrained index.
We have seen an uptick in supply from high quality issuers in the European high yield bond market this year. 49% of bonds were BB-rated (vs. 38% during 2014) and 41% B-rated, while lower rated CCC bond volume represented only 6%, the lowest proportion since 2010*.
In the US the energy and commodity related sectors represent approximately 17% of the high yield market, which deteriorated during 2015 and accounted for more than 70% of 2015’s default volume. Specifically, 17 Energy companies totaling $15.1bn and 5 Coal companies totaling $11.8bn defaulted in financial year 2015. Excluding these troubled sectors only 15 companies totaling $10.9bn defaulted in 2015.
Despite that, the Last Twelve Month (LTM) default rate in the US high yield market, as measured by the BofA Merrill Lynch US High Yield Constrained Index, was 1.82% at the end of December 2015, which is much lower from the long term default average of 3.77% (chart 2). Energy and Metals/Mining (Coal) defaults significantly propped up the LTM par-weighted default rate, and excluding these commodity sectors, the default rate falls to 0.30%.
In addition, the level of spreads currently implies a default rate of approximately 6.5%, which is clearly much higher than the current and long term average default rates, and suggests that investors are over-compensated for the risk they are exposed to.
Finally, net issuance in the US was dominated by higher quality issuers (60.3% for BB-rated and 34.7% for B-rated credits) as CCC-rated issuance represented just 5.1% of total volume for the year.
Looking ahead, we expect defaults to remain well below 1% during 2016 in Europe as the European central bank continues to provide liquidity support to the market keeping credit conditions favourable. The US default rate is expected to increase to 2.5-3.5% driven largely by commodity – related issuers. As credit quality of both markets improves, we believe that valuations are attractive and view the recent market moves as a potential buying opportunities in fundamentally sound high yield credits.
* The remaining 4% (approximately) is NR