Executive Summary
The year 2005 turned out to be below average for the high-yield bond market with rising defaults, reduced new financings, barely positive returns and lower excess returns versus ten-year Treasuries. The annual dollar denominated default rate increased by more than 2% to 3.37%, based on a mid-year market population size of $1,073 billion. The market size increased by over $100 billion from one year earlier, fueled by a large surplus of fallen angels versus rising stars. The fourth quarter’s default rate was 1.12%, over triple the prior year’s comparable quarterly rate - when the benign credit cycle was clearly still in effect. The annual dollar denominated default rate on leveraged loans (from S&P data) also increased considerably to 3.0% from last year’s 1.0% rate.
Default losses were up to 1.46% based on a weighted average recovery rate of just over 61%. The latter was a slight increase over last year’s 57.7% and is above what our regression model would have predicted. Fallen angel defaults were significant in 2005 with a 2.74% default rate based on six issuers.
New high-yield issuance in 2005 was $97.6 billion, down 34% from the record level in 2004. Returns on high yield bonds in 2004 were 2.08%, significantly below the historical average and just 4 bp higher than ten-year Treasuries. Yield-to-maturity spreads to ten-year Treasuries increased in 2005 to 4.05% - 91 bp higher than last year’s extremely low level, but still 82 bp below the historical average.
The distressed ratio of high yield bonds trading 1,000 bp over the risk-free rate declined by year-end to 4.75% of the market’s size and just 4.1% of the high yield plus defaulted debt markets’ size. This is a relatively low proportion and reflects a combination of low expected default rates by the market and a large amount of previously distressed debt that defaulted in the fourth quarter. Still, the distress ratio was higher in 2005 than at the end of 2004. And, the supply of distressed and defaulted bonds, bank loans and other debt increased by over $100 billion in 2005. Based on our mortality rate methodology on recent new issuance to forecast default levels in 2006, the relatively high levels of new issuance in 2003-2005 rated B- or below bodes for higher default rates in 2006. While still below the historical average, we believe the expected default rate could increase to 3.75%-4.25% in 2006. These forecasted rates are higher, however, than implied rates from end-of-year yield spreads. Our forecasted default rate in 2007 is for an even higher rate - one that is higher then the historical weighted average rate of 4.7%.
fyi - Registration to download is free. There is some interesting historical stuff on default rates, etc.
- Alec
