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Corporate Bonds: Can Default History Predict the Future?

Elizabeth Henderson, CFA
Director of Corporate Credit
AAM Insurance Investment Management
ehenderson@aamcompany.com, 312-263-2900

The rating agencies are predicting that defaults for speculative-grade bonds will peak somewhere between 14% and 16% in 2009. Many analysts and pundits are quick to point out that the last time high-yield defaults reached double digits was in 1932-1933, during the Great Depression.

Out of necessity, that was also a time when bankruptcy legislation was enacted to give corporations more flexibility to reorganize. Investment-grade defaults reached 1.2% in 1935 and then peaked at 1.6% in 1938, the year the Chandler Act introduced reorganization chapters into bankruptcy law. At that time, the high-yield market did not exist. Today, there is not only a high-yield market, but the bankruptcy code has been further relaxed and reorganizations (i.e., “cram downs”) outside of bankruptcy court—defined as “defaults” by the rating agencies—have become more commonplace. Other factors at work are the ballooning of credit and more borrower-friendly covenants, which allow distressed companies to operate longer, delaying the inevitable.

Investors make questionable assumptions

Despite these facts and the weak economic outlook, many Wall Street strategists and investors believe that investment-grade corporate bond spreads imply an investment-grade default rate that far exceeds the highest level in history (1.6% in 1938). These strategists define this “implied” default rate as the break-even default rate by setting expected loss given default equal to the coupon yield.¹ The inputs are recovery estimates for unsecured bonds for that year and the current coupon yield and price for the investment-grade index in which implied default rate = coupon/price x price/(price-recovery).

Using this methodology, Wall Street investors have calculated a default rate almost six times the historic high point (8.9% vs. 1.6%). They have used this rate to support the claim that defaults would not reach such a level and, therefore, spreads were too wide. This reasoning is an implicit buy recommendation for corporate bonds.

Back testing this theory using Moody’s recovery statistics and index data from Barclays Capital Investment Grade Credit Index shows little correlation with spreads and implied default rates and no statistical significance. As Exhibit 1 indicates, the implied default rate is always much higher than the maximum level for investment-grade defaults reached in 1938. Because both U.S. Treasury yields and spreads affect the index price, the implied default rate can increase even when spreads are low.

Another erroneous claim made late in 2008 was that spreads peak early, before a recession ends and defaults peak, so now is a good time to invest in corporate bonds. Exhibit 2 illustrates that since 1973, spreads typically peak a year before defaults and at various points during a recession, shown in the area between the bars.

A regression analysis would conclude that spreads are leading indicators of defaults and are wider in recessions. However, both variables explain only 35% of the variability in spreads, and there is no pattern of when spreads peak during a recession. This is not surprising, as numerous factors affect spreads. 

This is not to say that analysts do not believe there is value in certain investment-grade corporate bonds or that there is the potential for surpassing the default rates in the Depression era for investment-grade debt given the credit market conditions, structural differences and deleveraging that need to take place. Spreads widen in anticipation of defaults, not in reaction to them. However, the decision to get more aggressive with corporate bonds cannot be made using data-mined statistics.

This study highlights that while historical patterns are important to track, they should not always be used as a road map. Until there is reason to be bullish from a fundamental perspective, AAM Insurance Investment Management will remain defensive when investing in corporate bonds. 

AAM is a registered independent investment advisor, specializing in the management of insurance company assets.

Questions about corporate bonds? Contact AAM’s Elizabeth Henderson at 312-263-2900.

¹Merrill Lynch, “Year Ahead—Credit Markets,” Dec. 19, 2008.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.