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What do high-yield credit spreads imply for default rates?

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      By Jeffrey D. MuellerCo-Director of High Yield Bonds, Portfolio Manager, Eaton Vance Advisers International Ltd. and Stephen C. Concannon, CFACo-Director of High Yield Bonds, Portfolio Manager, Eaton Vance Management

      London - In the purest sense, credit spreads reflect the potential compensation a bond investor can earn for taking on a given level of credit risk. Based on the credit spread, we are therefore able to make assumptions about how severe the default risk associated with an investment is perceived to be by the market.

      To this end, the table below serves as a useful tool for contextualising what the recent widening of credit spreads means today and what further widening might mean from a default perspective into the future.

      HY_DEFAULTRATES

      If we take 900bps of credit spread as an example and assume an annual recovery rate of 40% (loss rate of 60%), that would imply that 15% of companies would need to default every year for the spread compensation on offer to investors to be wiped out.

      The formula underlying these calculations is relatively straightforward: We take an annual default rate of 15% and multiply that by an implied loss rate of 60% to equal losses of around 9.00%, or 900bps.

      Let's look at a more extreme scenario and assume a recovery rate of just 20% (loss rate of 80%). At this level, 11.3% of issuers would need to default, every year, for the credit premium paid to investors to be wiped out. On a five-year view, that would indicate that the market believed 56.3% of issuing companies in existence would fall into default.

      As a point of reference, at the close of trading on 19 March 2020, credit spreads across the different high-yield markets were near these levels at 870 basis points (bps) for Europe, 956bps for Global and 979bps for the US.1

      On a five-year basis, current levels for US high yield indicate that the market is currently pricing in defaults for 80% of issuers (at a 40% assumed recovery rate). In our view, it is excessively pessimistic to expect 80% of US high-yield issuers to default.

      Bottom line: Markets rarely trade only on fundamentals and the uncertainty surrounding the evolution of the current COVID-19 pandemic may well push spreads wider. That said, we believe that current levels may present an attractive entry point for investors who are highly selective in their approach and seek to allocate on a longer-term investment horizon.