Understanding High Yield Bonds: The Balance between Excess Spread and Excess Optimism

Current Yields of High Yield Bonds

Despite the US Treasury curve yielding above 4%, high yield bonds continue to offer mid-single digit yields. At the end of September, US high yield, European high yield, and emerging markets corporate high yield bonds were offering 7.0%, 6.1%, and 7.4% respectively. However, credit spreads have plunged to multi-year lows, leading to an ongoing debate between all-in yield versus credit spreads.

Importance of Credit Spreads

Credit spreads are significant because they need to overcompensate for future defaults at an index level. If they didn't, there would be no incentive to invest in high yield bonds. When adjusted for default loss, high yield returns would be on par with the risk-free rate. In worse cases, if default losses exceeded credit spreads, the returns would be less than the risk-free rate. Thus, credit spreads consist of two main components: default-implied spreads, which provide a forward-looking view on future defaults and recovery, and excess spreads, which represent the overcompensation of default risk. Active management aims to minimize default loss and maximize excess spread.

Calculating Excess Spreads

Excess spreads across the US, European, and emerging markets high yield markets can be calculated by subtracting the realized subsequent twelve-month default rate (adjusted by recovery value) from credit spreads. For instance, the US high yield market had credit spreads of 440bps in September 2014. The following 12 months saw a 3% default rate with a recovery rate of 40%, resulting in a default loss of 1.83%. Consequently, investors who bought US high yield in September 2014 enjoyed an actual excess spread of 257bps.

Excess Spread Over Time

Over time, the results are quite surprising. While the European high yield market consistently overcompensates for default risk, US high yield and emerging markets corporate high yield excess spreads were negative during some periods. This means that realized one-year default losses were greater than credit spreads a year earlier. However, these instances can be attributed to one-off events like COVID-19 for US high yield and the Russia/Ukraine conflict for emerging markets high yield.

Median Excess Spreads

Considering these factors, median numbers are deemed more representative. From January 2014 to September 2023, the median excess spreads of US, European, and emerging markets high yield were remarkably similar, ranging from 280 to 310bps. Using 300bps as our base case excess spread, we can derive the implied default loss expectation of the market for the next 12 months. As of the end of September 2024, the implied default loss expectations were 0.1% for US high yield, 1.4% for European high yield, and 0.9% for emerging markets high yield. This is in contrast to broker research expectations of 2.5-3% default rates for 2025, across the US, European, and emerging markets high yield markets.

Future Expectations

Even when adjusted for recovery rates, next year’s default losses are expected to be greater than what current credit spreads are pricing in. The big question for the next 12 months is which will prevail: excess optimism or excess spreads?

Bottom Line

The balance between excess spread and excess optimism in the high yield bond market is a fascinating topic. It raises questions about the future of the market and the potential risks and rewards for investors. What are your thoughts on this matter? Do you think excess optimism or excess spreads will prevail in the next 12 months? Feel free to share this article with your friends and discuss it. Remember, you can sign up for the Daily Briefing, which is delivered every day at 6pm.