Getting to grips with corporate bond default risk

With the rise of quantitative credit trading, investors are looking for novel data to better understand their investment risks and drive investment decisions through statistical models. A sub-market that investors frequently look to in search of yield is the high-yield corporate bond market. In that market, investors fear that the company will default on their debt, and they will lose their money! That is why, the most important risk to consider is the default risk when investing in these bonds.

What if our key analytical measures were able to accurately account for the default risk component? What insights can we get to drive investment decisions?

Let’s look at a Benchmark portfolio of 500 securities in the USD high yield market as an example. We will then construct a portfolio consisting of securities with low probability of default (PD) and a portfolio consisting of securities with high PD values. The portfolios were chosen at the beginning of the period 3 January 2020.

The first two figures should look familiar to most fixed income investors. Companies with a higher PD are likely to carry a higher spread and in case they do not default, are expected to have a higher return. With the same logic, companies with a low probability of defaulting have lower returns and spreads, hence the term: “high risk, high return.

The next two figures are more interesting. Here we construct measures that look at the bonds spread and yield while accounting for the possibility of the bond defaulting and future cashflows remaining unrealized. Such default-adjusted measures therefore quantify the default and non-default portions of risk. From these measures, an investor would expect that non-default yield and spread to be similar across different probability of default buckets, which is exactly what we observe before the pandemic hit. More specifically, it can be seen default-adjusted-yield fluctuates around 4% (below graphs) regardless of the PD of the bonds, while nominal yield is between 4% - 8% (above graphs), depending on the probability of default of the bond. Similarly, when the market is more comfortable with COVID toward the end of 2021, yields and spreads converge again to a similar level.

However, this does not seem to hold during the peak of the COVID crisis around March 2020. The yields and spread of the high PD and low PD portfolios diverge significantly, which cannot be easily explained by default risk. The non-default yields on low PD bonds rise from 4% to 6%, while those of high PD bonds rise from 4% to 12%. This shows that other considerations are also being reflected in market behavior, and the increase in yields and spreads in not solely due to increased risk of default. Investors could further research whether such increases are justified after accounting for the default risk component.

What does this mean for investors?

This means that investors could benefit from tools that investigate and break down the individual components of risks that are involved with corporate bond investing. Quantifying and analyzing these risks could help them understand their portfolios better, especially during uncertain market conditions like the pandemic.

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