Historic Changes in the High Yield Bond Market

Abstract

In a history that now stretches about four decades, the high yield (HY) market has experienced growth in issuance and out‐standings that is remarkable both for its level (about 13% per annum, with HY bonds now accounting for about 25% of the total corporate bond market) and its cyclicality and sensitivity to the broad economy. The HY market has also experienced a notable shift away from B‐rated bonds and toward both lower‐risk Ba‐rated bonds and, to a lesser extent, more risky Caa‐rated bonds. Consistent with this development, studies of the performance of HY bonds show Ba‐rated bonds experiencing not only lower risk, but also higher returns than Caa‐rated bonds, which have produced surprisingly low average returns along with exceptionally high volatility. At the same time, studies of the correlation of HY bond returns with returns on other major asset classes report that all classes of HY bonds (but particularly the riskier B‐ and Caa‐rated bonds) have consistently stronger relationships with common stocks (especially small‐cap stocks) than with Treasuries and investment‐grade bonds.Analysis of the volatility of HY bond returns over time shows that during periods of stability in the economy and financial markets, the volatility of HY bond returns has been very similar to that of investment‐grade bonds. But during periods of political or economic uncertainty, the volatility of HY bonds has become two or three times that of investment‐grade bonds, approaching the volatility of common stocks. The main driver of the significant increase in the risk of the aggregate HY bond market during periods of uncertainty has been Caa‐rated bonds, whose risk pattern has been remarkably similar to that of small‐cap common stocks.Analysis of the credit risk spread (or CRS) series for both the composite HY bond market and each of its rating categories shows markedly non‐normal distributions with significant positive “skewness”—that is, periods of exceptionally high spreads (that are not counterbalanced by periods of exceptionally low spreads). The authors also report a consistently strong relationship of the CRS series with default rates and the general state of the economy, with major peaks occurring during or shortly after economic recessions.Near the end of 2008, however, there was a clear break in this relationship when the CRS reached an historic peak of 2,000 basis points, or more than five standard deviations above its long‐term mean, while the default rate (at 4%) was below its long‐term average. The authors offer two explanations for this break in CRS‐default rate relationship: the jump in the CRS caused by the extreme flight to quality and drop in liquidity for all risky securities during the second half of 2008; and the use of covenant‐lite securities and other sources of financial flexibility that appear to have enabled many HY issuers to defer defaults (if not avoid them entirely).