Dominic Tatakis
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.
OAS of three portfolios over time
Yield for three portfolios over time
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.
Default Adjusted OAS of three portfolios over time
Default Adjusted yield for three portfolios over time
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.
Legal Disclaimer
Republication or redistribution of LSE Group content is prohibited without our prior written consent.
The content of this publication is for informational purposes only and has no legal effect, does not form part of any contract, does not, and does not seek to constitute advice of any nature and no reliance should be placed upon statements contained herein. Whilst reasonable efforts have been taken to ensure that the contents of this publication are accurate and reliable, LSE Group does not guarantee that this document is free from errors or omissions; therefore, you may not rely upon the content of this document under any circumstances and you should seek your own independent legal, investment, tax and other advice. Neither We nor our affiliates shall be liable for any errors, inaccuracies or delays in the publication or any other content, or for any actions taken by you in reliance thereon.
Copyright © 2023 London Stock Exchange Group. All rights reserved.
The content of this publication is provided by London Stock Exchange Group plc, its applicable group undertakings and/or its affiliates or licensors (the “LSE Group” or “We”) exclusively.
Neither We nor our affiliates guarantee the accuracy of or endorse the views or opinions given by any third party content provider, advertiser, sponsor or other user. We may link to, reference, or promote websites, applications and/or services from third parties. You agree that We are not responsible for, and do not control such non-LSE Group websites, applications or services.
The content of this publication is for informational purposes only. All information and data contained in this publication is obtained by LSE Group from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data are provided "as is" without warranty of any kind. You understand and agree that this publication does not, and does not seek to, constitute advice of any nature. You may not rely upon the content of this document under any circumstances and should seek your own independent legal, tax or investment advice or opinion regarding the suitability, value or profitability of any particular security, portfolio or investment strategy. Neither We nor our affiliates shall be liable for any errors, inaccuracies or delays in the publication or any other content, or for any actions taken by you in reliance thereon. You expressly agree that your use of the publication and its content is at your sole risk.
To the fullest extent permitted by applicable law, LSE Group, expressly disclaims any representation or warranties, express or implied, including, without limitation, any representations or warranties of performance, merchantability, fitness for a particular purpose, accuracy, completeness, reliability and non-infringement. LSE Group, its subsidiaries, its affiliates and their respective shareholders, directors, officers employees, agents, advertisers, content providers and licensors (collectively referred to as the “LSE Group Parties”) disclaim all responsibility for any loss, liability or damage of any kind resulting from or related to access, use or the unavailability of the publication (or any part of it); and none of the LSE Group Parties will be liable (jointly or severally) to you for any direct, indirect, consequential, special, incidental, punitive or exemplary damages, howsoever arising, even if any member of the LSE Group Parties are advised in advance of the possibility of such damages or could have foreseen any such damages arising or resulting from the use of, or inability to use, the information contained in the publication. For the avoidance of doubt, the LSE Group Parties shall have no liability for any losses, claims, demands, actions, proceedings, damages, costs or expenses arising out of, or in any way connected with, the information contained in this document.
LSE Group is the owner of various intellectual property rights ("IPR”), including but not limited to, numerous trademarks that are used to identify, advertise, and promote LSE Group products, services and activities. Nothing contained herein should be construed as granting any licence or right to use any of the trademarks or any other LSE Group IPR for any purpose whatsoever without the written permission or applicable licence terms.