It's no surprise that the higher return potential of high yield bonds usually comes with greater default risk than investment-grade corporate and government debt securities. But painting the asset class with a broad brush can mask big differences in defaults among the underlying rating tiers - a factor that's especially critical to assessing opportunities and risks in uncertain times.
For instance, the lion's share of high yield defaults historically have affected CCC rated issuers, which make up only about 12% of the high yield market today. Over the past 15 years, the average trailing-12-month default rates for BB and B rated credits - which represent 88% of today's market - were 0.5% and 1.7%, respectively, compared with a significantly higher 14.1% for CCC rated securities.1
Lower-rated bonds have also tended to suffer much more in slow-growth and recessionary economic environments, as well as during periods of elevated market volatility. For example, in the aftermath of the 2008 financial crisis, the trailing-12-month default rates for CCCs peaked at 51.9%, versus 15.6% for B rated credits and just 3.7% for BB rated credits.2A similar trend is found in previous economic downturns. And today, as the economy continues to grapple with the ramifications of the Covid-19 crisis, the trailing-12-month default rate for CCCs has reached 42.9%, while B and BB rated credits have maintained defaults at 1.65% and 0.14%, respectively, as of 30 September 2020.3
The magnitude of these rating-tier differences may be underappreciated by many investors, who could miss out on opportunities in the asset class as a result.
For further insight on the high-yield risk/reward spectrum, read the full version of this article.
1Bank of America Merrill Lynch as of 30 September 2020.
2Bank of America Merrill Lynch as of 30 September 2020. CCC default rate peak as of 31 July 2019; B default rate peak as of 31 March 2009; BB default rate peak as of 30 September 2009.
3Bank of America Merrill Lynch. CCC default rate peak as of 31 August 2020; BB and B default rates as of 30 September 2020.
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