Survival and Default of Original Issue High-Yield Bonds

Abstract

We study the default behavior of original issue high-yield bonds to answer the open question of how the probability of default changes over time. We use a flexible econometric method, the Cox proportional hazard, to model the default behavior of junk bonds over their life. The method allows us to include the impact of issue and issuer characteristics on the probability of and the time to, default in the estimation. Using a large comprehensive sample, we find that the bonds face a constantly increasing default risk over time, with the most significant increase beyond four years after issuance. Due to the higher costs of high-yield bonds, issuers will refinance their debt as their prospects improve. Only nonperforming issuers will keep their junk bonds outstanding over the medium to long run. Therefore, the default rate of high-yield bonds should exhibit an increasing pattern over time. In this paper, we suggest a new application for a semi-parametric proportional hazard model. This new application allows us to extract default probabilities of original-issue high yield (junk) bonds. This method largely avoids the estimation problems caused by the changing population of outstanding junk bonds, and we can use it to account for the impact of issue and issuer characteristics on the probability of, and the time to, default in the estimation. In contrast to earlier studies, we find strong evidence for default probabilities that increase monotonically as junk bonds age, with the most significant increase coming four years after issuance. We analyze several issue-years together without distortions through changing populations. To do so, we first identify several characteristics at the issue date that have an impact on the default of bonds. We use these variables to estimate a semi-parametric Cox proportional hazard model. Using the coefficient estimates, we can recover the baseline hazard functions and the instantaneous default probabilities over time. We also estimate a time-varying Cox proportional hazard model, using the time-varying spread between interest rates at the bond's issue date and current interest rates as an explanatory variable. This specification removes the impact of the general level of interest rates from our hazard estimations. The fact that we also observe the increasing risk of default in this setup suggests that our results would still hold in a period of stable interest rates. As junk bonds age, the increasing risk of default can be explained by the nature of this method of corporate financing. As with any kind of borrowing, higher-risk borrowers have to