Defaults and Returns on High-Yield Bonds: Lessons from 1999 and Outlook for 2000-2002 - junk bond market risk

Business Economics, April, 2000 by Edward I. Altman, Naeem Hukkawala, Vellore Kishore

Business economists must weigh the benefits from increased leverage with the costs (bankruptcy and agency costs) of heightened financial risk and financial fragility. This study serves as a reminder, both to fixed income and equity investors, that even in a robust economy there is still no substitute for careful fundamental analysis at the firm level.

Full year 1999 was a mixed performance year for the high-yield bond market in the United States and other developed countries (Canada, Europe, and Australia) but for different reasons than the mixed 1998 performance. Once again, total returns were lackluster, registering just 1.73 percent. But, unlike last year's negative return spread vs. U.S. ten-year Treasuries, the return spread in 1999 was a positive 10.1 percent, as yield spreads increased significantly and Treasuries tumbled. New issuance of high-yield bonds continued to be impressive, topping $100 billion for the third consecutive year. However, aggregate defaults increased dramatically to an all-time record level of over $23 billion (face value).

This substantial increase in default rates is important to consider, given the robust overall economic environment of the country. Although business failures are a normal, even desirable, attribute of any capitalistic economy, excesses could signal some generic vulnerability or at least pockets of distress. We conclude that despite the overall growth of our nation, certain industries either remain in poor health, or at least a significant number of firms continue to experience chronic problems (e.g., retailing, textiles). In addition, the rise in default rates signals deterioration in credit quality in recent leveraged financings. Losses to investors could dampen overall growth statistics and portend other problems. On the other hand, if the economy is becoming overheated, as some have argued, distressed events could play a positive role in keeping a lid on the pressure. We would be concerned if these above average default rates persist in the coming year, however.

Our study serves as a reminder both to fixed income and equity investors, that there is still no substitute for careful fundamental analysis at the firm level. In particular, business economists, in their advice to management, must weigh the benefits from increased leverage with the costs (bankruptcy and agency costs) of heightened financial risk and financial fragility.

The default rate registered a sizeable increase, topping four percent (4.15 percent) for the first time since 1991 and significantly above the 1.6 percent level of one year earlier. Combined with a relatively low recovery rate of below thirty cents on the dollar, the default loss rate was 3.2 percent in 1999, compared to a historical arithmetic annual average of 1.9 percent. Despite 1999's low absolute return, net returns (after deducting losses from defaults, rating migrations and interest rate changes) for the 1978-1999 period continued to show an attractive compounded return spread over U.S. Treasury bonds of close to 3.0 percent per year (2.96 percent).

This article documents the high-yield bond market's risk and return performance by presenting traditional and mortality default rate statistics and providing performance statistics over the relevant periods of the market's evolution. Our analysis covers the 1971-1999 period for defaults and the 1978-1999 period for returns. In addition, we present our annual forecast of expected defaults for the next three years (2000-2002).

Our 1999 forecast was for substantially higher defaults than 1998, but we underestimated the record default levels. Default levels and rates swelled in 1999 due to a number of factors, including the huge new issuance in the 1997-1999 period, a trend toward earlier defaults, deteriorating credit quality of new issues, pockets of industry fragility, and the continued vestige of 1998's flight to quality. For 2000, we expect default levels to decline to about $17.5 billion and the default rate to regress to around three percent of the amount outstanding.

Default Rates

During 1999, a record $23.6 billion of developed-country high-yield straight bonds defaulted or were exchanged under distressed conditions. This amount was comprised of 149 issues from 100 defaulting companies and resulted in a default rate of 4.15 percent. This compares to just fifty-three issues from thirty-seven companies in 1998. The 1999 default rate is considerably higher than last year's rate (1.60 percent), above the historic weighted average annual rate from 1971-1999 of 3.22 percent per year (2.6 percent arithmetic average rate), and is also above the median annual rate (1.60 percent) over the same twenty-nine-year period. This is shown in Figure 1. The face value of defaults reached record levels, topping the old record from 1991 by almost $5 billion. Of course, the high-yield market is now about three times larger than it was in 1991, thirty-three times larger than in 1981, and eighty-one times larger than in 1971.