Junk Bond default rates

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coachz
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Junk Bond default rates

Post by coachz »

Does this 2.4% default rate mean the high yield (junk) bond investors lost all of their money?

http://www.pionline.com/article/2015012 ... 2014-at-24
nordlead
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Re: Junk Bond default rates

Post by nordlead »

coachz wrote:Does this 2.4% default rate mean the high yield (junk) bond investors lost all of their money?

http://www.pionline.com/article/2015012 ... 2014-at-24
A default just means the obligation wasn't paid in full as agreed.

The 2.4% default rate appears to be in terms of cash value (not number of borrowers) in the high yield market. If an investor was invested 100% in a single company that defaulted and was unable to pay back anything on the bond, then yes, they would have lost all of their money. However, a default could also mean they can pay $0.80 on the dollar and that is what is negotiated in bankruptcy.
Valuethinker
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Re: Junk Bond default rates

Post by Valuethinker »

Recovery rates and default rates are unfortunately correlated.

That is to say, when the default rate rises, the amount recovered post default rises.

From memory, the average recovery on a corporate default is something like 60 cents on the dollar. For junk/ high yield though it is much lower, 35 cents?
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Re: Junk Bond default rates

Post by abuss368 »

I think the best investor's take risk with equities. Bonds are for safety and income. High Yield or "Junk Bonds" function somewhat like equities in a downturn. Government and investment grade bonds allow investors to stay the course and also rebalance back into equities.
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mptfan
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Re: Junk Bond default rates

Post by mptfan »

coachz wrote:Does this 2.4% default rate mean the high yield (junk) bond investors lost all of their money?
No, this is a popular misconception. Default is defined as not complying with all the terms of the bond, and it does NOT meant that the investor lost all of their money, or even that they lost any money at all. Moody's defines default as "any missed or delayed disbursement of interest or principal, and this includes companies that make a delayed payment within the grace period." See page 9 of the paper published by Moody's Investor Service in this link for the definition...

http://www.fonsrisksolutions.com/Docume ... 0Study.pdf

For example, let's say ABC company has issued a 10 year $1 million bond at 6% interest, and they agreed to pay the bondholder $5,000 on the last day of each month, but one month they are not able to make a timely payment, and instead they make the payment on the 15th of the following month. Technically, that bond was in default because the company did not comply with all the terms of the bond, but the bondholder did not lose any money, except the interest for 15 days on the interest payment that they did not timely receive. If ABC company continues to make all other payments on time, and repays the principal at maturity, the bondholder would not lose anything even though the bond would be technically "in default."

Of course it is true that a default could include the failure to pay interest payments at all, or a failure to repay the principal at all, and it is possible for a bondholder to lose all of their money, but you cannot determine that just by looking at the default rate, but rather, the recovery rate. I don't recall the exact numbers, but I recall generally that in the majority of defaults the bondholder gets some or most of their money back.
Last edited by mptfan on Tue Jun 09, 2015 12:06 pm, edited 2 times in total.
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Re: Junk Bond default rates

Post by abuss368 »

mptfan wrote:
coachz wrote:Does this 2.4% default rate mean the high yield (junk) bond investors lost all of their money?
No, this is a popular misconception. Default is defined as not complying with all the terms of the bond, and it does NOT meant that the investor lost all of their money, or even that they lost any money at all. Moody's defines default as "any missed or delayed disbursement of interest or principal, and this includes companies that make a delayed payment within the grace period." See page 9 of the paper published by Moody's Investor Service in this link for the definition...

http://www.fonsrisksolutions.com/Docume ... 0Study.pdf

For example, let's say ABC company has issued a 10 year $1 million bond at 6% interest, and they agreed to pay the bondholder $5,000 on the last day of each month, but one month they are not able to make a timely payment, and instead they make the payment on the 15th of the following month. Technically, that bond was in default because the company did not comply with all the terms of the bond, but the bondholder did not lose any money, except the interest for 15 days on the interest payment that they did not timely receive. If ABC company continues to make all other payments on time, and repays the principal at maturity, the bondholder would not lose anything even though the bond would be technically "in default."

Of course it is true that a default could include the failure to pay interest payments at all, or a failure to repay the principal at all, and it is possible for a bondholder to lose all of their money, but you cannot determine that just by looking at the default rate. I don't recall the exact numbers, but I recall generally that in the majority of defaults the bondholder gets some or most of their money back.
Hi mptfan,

Excellent post explain to Bogleheads the definition of "default" and the many variables that impact it.

Best.
John C. Bogle: “Simplicity is the master key to financial success."
Valuethinker
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Re: Junk Bond default rates

Post by Valuethinker »

mptfan wrote:
Of course it is true that a default could include the failure to pay interest payments at all, or a failure to repay the principal at all, and it is possible for a bondholder to lose all of their money, but you cannot determine that just by looking at the default rate. I don't recall the exact numbers, but I recall generally that in the majority of defaults the bondholder gets some or most of their money back.
http://people.stern.nyu.edu/ealtman/Review1.pdf gives you default data (table 1 at the back)

http://www.federalreserve.gov/pubs/feds ... 510pap.pdf

see also chart on p 31 above.

http://www.occ.treas.gov/publications/p ... 2011-2.pdf

p28 has up to date data (2011)

https://www.isdadocs.org/c_and_a/pdf/An ... 010702.pdf

p 86 summarizes studies.
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coachz
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Re: Junk Bond default rates

Post by coachz »

great info here as always. Thanks ! :sharebeer
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Re: Junk Bond default rates

Post by kolea »

What I have always wanted to know is how defaults affect a HY bond fund like VWEHX. They don't report defaults or recoveries in the annual report that I could find so it is hard to know exactly what the effect is. I assume that unrecovered defaults are simply written off the account and thus are reflected in the NAV for the fund. In that case you could sort-of see how defaults might affect the fund by looking at the history of the NAV over the 2008/9 financial crisis. But lots of things affect NAV so it is hard to know what exactly is due to defaults, and what is due to other factors. In any event, the pre-2008 NAV for VWEHX was about $6, and four years later, it was back up to $6.
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Johno
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Re: Junk Bond default rates

Post by Johno »

TwoByFour wrote:What I have always wanted to know is how defaults affect a HY bond fund like VWEHX. They don't report defaults or recoveries in the annual report that I could find so it is hard to know exactly what the effect is. I assume that unrecovered defaults are simply written off the account and thus are reflected in the NAV for the fund. In that case you could sort-of see how defaults might affect the fund by looking at the history of the NAV over the 2008/9 financial crisis. But lots of things affect NAV so it is hard to know what exactly is due to defaults, and what is due to other factors. In any event, the pre-2008 NAV for VWEHX was about $6, and four years later, it was back up to $6.
Yes this is difficult to assess from POV of expected return. Say the SEC yield of the Vanguard High Yield Corporate Fund (VWEAX in Admiral form) is 5%. Forget for a moment any components of 'expected' yield from yield curve dynamics, like 'roll yield', aka term premium. What needs to be subtracted from 5% in terms of default losses to get an expected return? It's hard to determine. It's perhaps even hard to define in some cases. As we know, investment grade corporate bond funds suffer significantly, relative to their much narrower spreads to treasuries, from selling bonds which get downgraded to junk, it's relatively unusual for such funds to directly suffer default losses. But junk funds might also do this to some degree, especially an actively and relatively conservatively managed one like VWEAX. If the managers sell a bond of a company whose story they liked when it was rated BB, when the story doesn't pan out and the bond has been downgraded to CCC, this wouldn't necessarily count as 'default' loss even if they specifically disclosed default losses, but would still be a loss dues to credit deterioration.

And as has been pointed out, it's possible for holders of some corporate bonds to come away with more when a company defaults than holders of other companies come away with when they sell after the company gets greatly downgraded but doesn't default. The other variable also to mention wrt to default recovery is the price of a bond after a default is declared, which is when 'conventional' holders like a junk fund would probably sell it, and the final settlement of the restructuring or liquidation, which would generally go to 'vulture' investors specializing in buying defaulted bonds for generally less (though obviously at risk of buying them for more) than the final settlement awarded to bondholders in restructuring or liquidation.

Another thing is that numbers like 2.8% would represent a certain cross section of credits, perhaps typical of an index junk fund like the ETF's HYG or JNK but not representative of actively managed funds. The Vanguard one has a notably higher average rating (and lower yield) than indexes and default rate is very skewed by rating, before even considering the choices of an active manager among bonds.
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Re: Junk Bond default rates

Post by grayfox »

Bonds with credit risk are much more complicated than default-free government bonds. With default-free G-bonds, you always get your interest and principle payments on time. If you want safety of principal, invest only in default free bonds.

Investment-grade corporates are more complicated than default-free G-bonds, but the default rates are generally low. SEC Yield is a fairly good predictor of the actual return most of the time.

Image

Low-grade bonds, a.k.a junk bonds, on the other hand, are really complicated, and the default rates can be very high. SEC Yield is a poor predictor of the actual return. On average, the actual return has been about 240 bps worse than the SEC Yield predicted.

Image

:arrow: If you invest in Vanguard VWEHX and read that the SEC Yield is 4.90% like it shows today, do not expect to get 4.90% I would subtract 240 bps off that and set my expectations at about 2.50%, with a very large variance, over the next 5 years.
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Re: Junk Bond default rates

Post by garlandwhizzer »

TwobyFour wrote:
Postby TwoByFour » Tue Jun 09, 2015 1:45 pm

What I have always wanted to know is how defaults affect a HY bond fund like VWEHX. They don't report defaults or recoveries in the annual report that I could find so it is hard to know exactly what the effect is.
My understanding is that the Vanguard HYB fund sells its bonds that have deteriorating fundamentals whenever default looks like an option in the near future. I believe that's why they don't seem to report any defaults from their bond holdings. When you sell distressed bonds such as these you have to unload them at fire sale prices, so the fund loses money on them, lowering principal share value of the fund, but perhaps by less than they would have if default occurred. When a company defaults, bond holders are first in line as the company's assets are liquidated for cash. I believe bond holders typically recover an average about 60% of the original face value of the bonds after this process unwinds. However this liquidation process takes time so it is dead money for a time, another reason why Vanguard unloads the bonds at a loss prior to the official default.

Vanguard's selection of higher rated junk bonds as compared with most junk bond funds also tends to reduce defaults relative to other such funds. If you're looking for a HYB fund (which most of us aren't) Vanguard's is one to seriously consider. HYB funds typically tank during financial crisis and recession, when you need stability the most, but tend to outperform other bond funds during inflationary environments due to its shorter durations, higher yields, and the fact that inflation is generally associated with a economy that is growing at least in nominal terms, making it easier for marginal companies to repay fixed nominal debt.

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grayfox
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Re: Junk Bond default rates

Post by grayfox »

Image

BTW, from this chart, it looks like 2009 was a great time to invest in VWEHX. The price had crashed and junk bonds were dirt cheap. The SEC Yield spiked up to over 13% for a short time.

The low price is also what made the 5-year return of investments made around 2004 so poor, with actual dollar losses.

I have seen the suggestion that you buy junk bonds when there is a wide spread between junk and investment-grade bonds. This sounds reasonable to me. I would not being holding VWEHX at this time with SEC Yield only 4.9%, while Intermediate-Term corporate bond fund (VICSX) has SEC Yield = 3.25%

At this time, Mutual Fund VICSX or ETF VCIT looks better then VWEHX. Why pay a lot for junk, when the better stuff is not much more?
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Re: Junk Bond default rates

Post by mptfan »

grayfox wrote:Why pay a lot for junk, when the better stuff is not much more?
Because the yield is higher.
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