Higher Rates, Higher Yields, and Higher Distress

We have all become painfully aware that the bond market has experienced the most difficult first half many investors have seen in their careers.  No spread sector was immune from the sell-off as growth concerns increased and investors sold risk assets.  Some suggest the resulting spread widening has created a better risk/reward return profile while contemplating the ‘right’ time to take advantage of the opportunity.  One measure to consider when evaluating the fixed income landscape is the high yield market distress ratio.

There are different measures of this market distress ratio.  For the purposes of this note, we will use the proportion of high yield rated issuers with at least one security that has an option-adjusted spread (OAS) greater than 1,000 basis points over a U.S. Treasury security with a comparable maturity.  While the precise spread level is less important, we use a 1,000 basis point OAS as a cut-off point simply due to its usefulness in highlighting historical levels of corporate distress.  Additionally, much work has been done highlighting that the movement in this market distress ratio tends to move similarly to corporate default rates, with varying lead time.

As of June 30, 2022, the high yield market distress ratio stood at 15% (see exhibit 1).  In isolation, that is not very informative, but when investors look at that figure in comparison to historical averages and trends, it puts recent market performance into perspective.  The average market distress ratio since January 30, 1997, is 17%.  On the one hand, a market distress ratio that is approximately 2 percentage points lower than average does not appear to be such a bad position; however, looking at recent trends may cause concern.  As of December 31, 2021, the market distress ratio was an exceptionally low 3%.  In just six months, the level of stress in the high yield bond market has increased nearly 5 times.

Looking at this change from another perspective, one can see the cracks appearing in the lower quality portion of the high yield market.  The CCC and lower rated segment of high yield has a distress ratio of approaching 50% as of June 30, 2022, up from nearly 14% at year end, and above its long-term average. Issuers who have highly levered capital structures and are closest to potential default increased 3.5 times.  In contrast, the higher quality BB-rated tier of the high yield market was essentially unchanged at 0.26%.  It’s also worth noting that level is materially below the long-term average of nearly 3%.

Exhibit 1 – Market Distress Ratio

		Average	Average (No GFC)	12/31/2021	6/30/2022
Total HY		17.15%	15.25%	3.14%	15.21%
Ratings	BB	3.40%	1.97%	0.25%	0.26%
	B	11.55%	9.48%	0.85%	11.28%
	CCC and lower	44.08%	42.52%	13.98%	49.45%

Source: BAML High Yield Index (H0A0), Boyd Watterson Asset Management.

The trends suggest that the default rate, particularly for the lower quality portion of the high yield universe, will likely be pressured higher in the coming months.  Investors seeking a more conservative position in the high yield market may consider an emphasis on higher quality, high yield issuers given the current landscape.

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.