After speaking to many investors over the last year about the opportunity of being short high yield bonds of vulnerable and challenged companies, I think the most common misconception is that there is nothing to do until default rates spike. Many market prognosticators are calling for significant spikes in the US corporate high yield default rate, starting in 2016 and likely sustaining to 2018-2020. Does that mean that we should try to time being short closer to 2016? The answer is unequivocally no…Once default rates start to spike, the short trade is most likely near its end and one should be thinking about buying asymmetrically priced, defaulted or distressed bonds where you have multiples of upside available.
As an example, during 2007 and 2008 the annual default rate was below 2% every month with the exception of December 2008. December 2008’s final default rate number didn’t come out until mid-January 2009. Had you waited for a spike in rates in order to start putting short high yield bond trades on, you would have had about the worst timing possible as markets essentially went on an unabated six year run straight up starting in March 2009.
With special thanks to Dr. Altman, Brenda Kuehne and the rest of the NYU research team for data, please see the below chart which shows the quarterly default rate, the 12-month moving average default rate and the index of defaulted debt securities. You can simply see that every period of persistently low default rates is followed by extended periods of negative price performance in the index. Every period of extraordinarily high spikes in the default rate is immediately followed by strong positive price performance in the index. Extended periods of low default rates are a LEADING INDICATOR OF SPIKES IN DEFAULT RATES.
We think that the time is now to be short of the most vulnerable and challenged high yield corporate bonds. Most of these companies have been consistent underperformers over the better part of the last decade, have cyclical or secular headwinds, are in serious danger of default or restructuring and are strangely trading at prices at or above par. Take advantage of the asymmetry available today and the fact that we have had 15 consecutive quarters of annualized defaults below 2.2%.