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“ The basic attraction of high-yield bonds can be
DEFAULT RATES
separated into two distinct components that together
historically, high-yield spreads typically lead default
make up investors’ total returns: price return and
rates by six to nine months, estimates youngberg. As
coupon return.”
spreads have narrowed, so too have Moody’s 12-month
default rate forecasts for speculative-grade companies.
For several months, the rating agency had been
predicting that default rates would be worse in Europe
than in the US—that’s no longer the scenario.
A default/return analysis quickly highlights the strength of the argument.
It is now predicting that European default rates will
peak at 12 percent in the first quarter of 2010, while in
Take a worst-case scenario, employing a 15 percent default rate, which is substantially higher
the US and globally, default rates will peak in the fourth
than Moody’s expectations over the next year. Add back a 30-cent recovery rate, as several of
quarter this year at 12.7 and 12.2 percent respectively.
those distressed defaulters will eventually pay back a portion of what they owe. Also, add in a
widening of spread of 100 basis points over the next year. In such a worst-case scenario, the
global junk-grade default rates increased to 10.7 percent
expected return is -5.6 percent.
in July, surpassing the 2002 peak of 10.4 percent, up from
the revised 10.3 percent in June. however, the level still
yet, the strength of the income return is a clear buffer, with a coupon yield of nearly 10
remains well below the 1991 peak of 12.2 percent.
percent helping to offset the negative price return from defaults, low-debt recovery and the
possibility of spread movement.
default rates among European speculative-grade
bonds rose from 4.2 percent in June to 4.6 percent
historically, average annual total returns are roughly nine percent, further supporting
in July. In the US, default rates edged up from 11.2
youngberg’s belief that, even in the worst-case scenario, investors are relatively shielded.
percent in June to 11.5 percent in July 2009.
Using a more modest 7.5 percent default rate, which is still higher than Moody’s estimate of
default rates in the US are expected to fall sharply,
4.4 percent, and using a similar 30-cent recovery and a 300 basis point spread narrowing, the
according to the rating agency, to 3.8 percent 12
expected return will top 17 percent over the next 12 months, says youngberg. This, he adds, is
months from now. The decline in Europe will be less
a much more realistic scenario over the next year.
acute, dipping to 8.7 percent by July 2010.
Combined, the global Moody’s default rate will be at
DEMAND
around 4.4 percent in a year’s time.
Market support and demand are now being driven by mutual funds, pensions and insurance
funds. This suggests that a more permanent, fresh pool of long-term liquidity is investing in
COUpON pOWER
the increasingly global market, says youngberg.
With the default rate and other factors in mind,
A sign of that potential strength can be seen in the fact that high-yield US mutual funds have
youngberg points to the “power of the coupon”.
experienced an influx of more than $12 billion in net inflows over the past year to date—a
sharp contrast from the negative flows for equity, global and emerging market debt.
he says that the basic attraction of high-yield bonds can
Aviva Investors is also well placed, having recently launched a new global high yield
be separated into two distinct components that together
bond Fund.
make up investors’ total returns: price return and coupon
return. For much of the past few months, the coupon
The fund, established last September, was set up to invest in below-investment-grade
return in the high-yield bond market has been between
securities, exactly the double and single b, and targeted triple C that have experienced such
0.8 percent and over one percent per month.
strong recent returns.
The return from the price is expected to be
It was the first fund to be launched under the Aviva Investors brand since the integration
significantly positive this year, says youngberg, but it is of Aviva Plc’s asset management businesses and has allowed investors to capitalise on the
the power of the coupon that ultimately enhances the attractive returns of high-yield bonds, when compared with other equity and fixed income
total return over a long time horizon. asset offerings.
“This provides a strong cushion against price And the global high yield bond Fund—with some $50 million under management—has
volatility,” according to youngberg. “It’s an attractive seen stellar performance. It rose by more than a quarter in the first six months to the end
combination, which both contributes on the upside and of June, outperforming peers, reflecting underlying fundamentals and the strength that is
protects on the downside.” Aviva Investors.
62 | INTELLIGENT INSURER | September 2009
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