High Yield Is Worth A Look

With high yield credit spreads near 540bp, is high yield a buy? Moody’s default rate outlook suggests it is, and that it could tighten 100-150bp from current levels in coming quarters. The one catch is that this scenario implies the economy continues to make steady if unspectacular progress in recovering from the coronavirus shock.

Even though there are a variety of emerging risk factors that could keep market conditions volatile for now, we think high yield is a buy for investors with medium-term horizons.

Default Rates Are Declining

Moody’s recently revised its default projection downward and now forecasts that the 12-month trailing default rate will peak at 11.4% in February 2021. Previously, Moody’s called for a peak rate of 12.1% in February 2021. Moody’s official forecast is for the default rate to fall to 10.4% by May 2021 and 8.9% in August. Moody’s market-based indicators imply default rates falling to 6.6-7.4% in May and 6-6.6% in August.

It is worth noting that high yield spreads tend to lead the default rate, gapping wider then snapping back often months ahead of the default rate (Figure 2).

Source: Bloomberg/Barclays, Moody’s Investors Service (MIS), Moody’s Analytics

This makes intuitive sense; markets are supposed to be forward looking.

But there is a more technical reason for this pattern. Moody’s reports the trailing 12-month default rate. Essentially, this is a moving sum of the past 12 months’ one-month default rate.^[1] During expansions when defaults are relatively low, the 12-month trailing default rate smooths out any seasonal variations and inevitable monthly variations in default activity. But during downturns and recoveries it lags badly.

When we extract the implied annualized one-month default rate implied by Moody’s 12-month trailing default rate (green and grey lines), we see that it soared to 18% in August then collapsed to 10% in September (Figure 1). We also calculate implied one-month default rates based on Moody’s projected market-based default rate (green line).^[2] These two measures settle into steady-state levels near 7% and 5.5%, respectively; at the same time, the trailing 12-month default rate peaks in February 2021.

It should come as little surprise that credit spreads tend to follow the ongoing one-month default rates when credit markets are under stress.

Credit Spreads Are Still Wide Relative to the Default Rate Outlook

What do the default rate projections tell us about the outlook for credit spreads? In the high yield market, credit spreads tend to reflect the default rate outlook over the foreseeable future times the loss rate. For example, if the default rate outlook is 5% and the recovery rate is 35%, the implied spread is 325bp, based on the following simple relationship:

Spread = Default Rate * (1 – Recovery Rate)

We use this relationship to estimate the credit spread implied by the projected 12-month trailing default and the one-month defaults implied by the trailing 12-month default rate and market factors (Figure 2). The black line shows actual monthly high yield spreads through late September. Investors who focus on the trailing 12-month default rate tend to think credit spreads tightened too far and too fast; they should trade more in line with the orange line. On the other hand, spreads based on one-month and market-implied default rates are about 455bp and 350bp, respectively.

If Moody’s default projections are on the mark, and the equity rally since March proves to be sustainable, then we expect high yield credit spreads can tighten from 540bp to the 400-450bp range in the foreseeable future, which could be anywhere from over the next few months to the next few quarters.

The One Catch: Have Equity Markets Correctly Flagged the Recovery?

This scenario depends critically on continued if unspectacular progress in the economy’s recovery from the coronavirus shock. Indications to date are constructive. Key parts of the economy, including retail sales and housing, have recovered sooner than expected, and the labour market is gradually improving. So far, the massive rally in equities since March seems to make increasingly more sense.

But needless to say, risk factors abound. Coronavirus infections are rising in the US and Europe, increasing the threat of more restrictions and possibly lockdowns. The US presidential election is a major uncertainty. The Supreme Court imbroglio all but guarantees that the Senate will not take up a new stimulus bill before the election and possibly not until the next president is inaugurated.

On balance, while these many factors may keep an element of volatility in markets and could cause the recovery to slow or stall, we think it highly unlikely that the known risk factors will cause another economic collapse and a major spike in default rates.

Given our medium-term horizon we would add to high yield positions at current spread levels.

1. The actual calculation takes into account additions and deletions from the rating universe and compounding. ↑

2. Moody’s market-based default rates are based on credit spreads and equity market indicators. ↑