High-Yield: An Inquisition

By JM
January 13, 2010

The Set-Up

• Low policy rates don’t impact speculative grade debt so much.

• Mortality rates for lower-rated debt are much higher than investment-grade debt;
the three year mark is where defaults really start to bite.

• Three years ago (2007), 51% of HY issuance was rated B or below.

• Mortalities have been accelerated by economic factors, but cumulative default rates
will still be high.

• A buy-and-hold strategy with a broad index of HY debt consistently outperforms the

Treasury benchmark. Trading strategies benefit from treasury positioning.

Uber-low interest rates don’t help HY as much

HY is much more equity-like than its higher-rated brethren because it depends on the
uncertain proposition of healthy cash flow. Top-line results necessary to cover interest cost
is not a given for HY, much more so than for investment grade credit. Below shows HY all
over the place in terms of interest rate sensitivity.

Duration Sensitivity of IG and HY straights

Low-Rated HY Has Much Higher Default Risk Over Time

Mortality Rates By Original Rating – All Rated Corporate Bonds* (1971 - 2007)

Cumulative Probability of Default in Years After Issuance 
   1  2  3  4  5  6  7  8  9  10 
AAA  0  0  0  0  0.04%  0.06%  0.07%  0.07%  0.07%  0.07% 
AA   0  0  0.29%  0.42%  0.44%  0.46%  0.46%  0.46%  0.51%  0.51% 
A  0.01%  0.08%  0.10%  0.15%  0.20%  0.28%  0.33%  0.54%  0.62%  0.66% 
BBB  0.31%  3.38%  4.63%  5.78%  6.44%  6.71%  6.93%  7.08%  7.19%  7.54% 
BB   1.13%  3.49%  7.62%  9.69%  11.90%  13.01%  14.42%  15.36%  16.79%  19.63% 
B  2.78%  9.22%  15.83%  22.93%  27.54%  30.65%  33.36%  34.93%  36.20%  36.80% 

CCC  7.88%  21.98%  36.56%  43.96%  46.26%  51.37%  54.07%  56.58%  57.02%  59.02% 
Source:  S&P 

Just Playing the Numbers (Independent of Macro Valuation Model), HY is Disaster

The three year mortality rate for B rated credit is 15.83%. The three year mortality rate for
CCC rated credit is 36.56%. And 51% of 2007 issuance of HY debt is rated B- or below!

Industrial Grade HY Revulsion imminent in 2010.

Percentage of New High-Yield Issues Rate B or Below based on Amount of Issuance

HY Returns over Treasuries

But generating returns on an annual basis over treasuries is tricky.

Source: Citigroup High-Yield Composite Index

Taking credit risk has its rewards over time, but the return over benchmark can be less than
200 basis points.

Source: Citigroup High-Yield Composite Index