The real junk yield
The truth is that it’s much riskier than it seems from doing this simple yield, or yield-spread, analysis. That’s because the annual loss rate for junk bonds over the past 35 years has been around 2.5%. You can arrive at the loss rate by adjusting defaults for recoveries. Default rates for junk average about 4.2% annually, according to research from Standard & Poor’s. And investors have typically recovered 41% (or lost a total of 59%) of those defaults, according to this Moody’s study from 1981 through 2008. That results in an annual loss rate of around 2.5%. So the fund’s 5% yield isn’t quite what it seems to be.
Our recovery rate may also be generous, because the Moody’s research includes senior secured bank loans, which are higher in the capital structure than junk bonds. This means if a borrower goes bankrupt, the banks get paid before the bond holders do. Still, sticking with this possibly generous recovery rate, owners of a junk-bond index-tracking ETF are staring at 2.5% annualized loss-adjusted returns relative to a 2.2% yield on the 10-year U.S. Treasury note. One could hardly call this 30 basis-point spread a reasonable margin of safety. If loss rates increase because of higher defaults or lower recovery rates, investors in junk bonds could well see returns lag those of a Treasury. Indeed, recovery rates declined during the energy-debt washout when oil prices declined, according to junk-bond maven Martin Fridson in a recent Barron’s article.
Read more here.
Jeremy Jones, CFA
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