Economic Undertakings

Controlling the risk of corporate bond default

Andrii Yalanskyi/iStock via Getty Images

By Dominic Tatakis, Analytical Product Manager, Quantitative Analyst, Yieldbook

With the rise of quantitative credit trading, investors are looking for new data to better understand their investment risks and guide their investment decisions through statistical models.

One submarket that investors frequently turn to in search of yield is the high yield corporate bond market. In this market, investors fear that the company will default on their debt, and that they will lose their money! Therefore, the most important risk to consider is the risk of default when investing in these bonds.

What if our main analytical measures were able to accurately take into account the default risk component? What information can we get to make investment decisions?

Let’s take the example of a benchmark portfolio of 500 stocks in the USD high yield market. We will then construct a portfolio composed of securities with a low probability of default (PD) and a portfolio composed of securities with a high PD value. The portfolios were chosen at the start of the period on January 3, 2020.

The first two numbers should sound familiar to most bond investors. Firms with a higher PD are likely to have a higher spread and, if they don’t default, should have a higher yield. In the same logic, companies with a low probability of default have lower yields and spreads, hence the expression: “high risk, high return”.

OAS of 3 wallets over time

Yield Book | FTSE Russell

Return for 3 portfolios over time

Yield Book | FTSE Russell

The next two figures are more interesting. Here, we construct metrics that examine bond spread and yield while accounting for the possibility that the bond will default and future cash flows remain unrealized.

These default-adjusted measures therefore quantify the default and non-default risk shares. From these metrics, an investor would expect yield and non-default spread to be similar across different PD buckets, which is exactly what we’re seeing before the pandemic hit.

Specifically, we can see that the default-adjusted yield fluctuates around 4% (charts below) regardless of the bond’s PD, while the nominal yield is between 4% and 8% (charts above) , depending on the default probability of the link. Similarly, when the market is more comfortable with COVID towards the end of 2021, yields and spreads again converge to a similar level.

Default adjusted OAS of 3 wallets over time

Yield Book | FTSE Russell

Default adjusted return for 3 portfolios over time

Yield Book | FTSE Russell

However, this does not appear to hold during the peak of the COVID crisis around March 2020. The returns and allocation of high PD and low PD portfolios diverge significantly, which cannot be easily explained by default risk.

Default-free yields on low-PD bonds rise from 4% to 6%, while yields on high-PD bonds rise from 4% to 12%. This shows that other considerations are also reflected in the behavior of the market, and that the increase in yields and spreads is not only due to an increased risk of default. Investors might research further whether these increases are justified after taking into account the default risk component.

What does this mean for investors?

This means that investors could benefit from tools that study and break down the individual risk components of investing in corporate bonds. Quantifying and analyzing these risks could help them better understand their portfolios, especially in uncertain market conditions like the pandemic.

This analysis was performed using The Yield Book as of 03/01/2022. The analyzes used are Option-Adjusted-Spread, Yield-to-Maturity, Default-Adjusted-Spread, Default-Adjusted-Yield. PD values ​​for metrics and companies are provided by the Credit Research Initiative, part of the National University of Singapore.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.