European high yield spreads over two times too wide, suggests Allianz GI

The spread on European high yield bonds is implying a five year default rate of 43%, over two times higher than the five-year rolling realised default rate since 1981.

This spread, of 700 basis points, comfortably justifies the risk taken investing at the lower end of ratings spectrum, says Allianz Global Investors.

“The market seems thus substantially overestimating the default risk.”

The German asset manager noted the average five-year default rate for B-rated bonds, between 1981 and 2010, was 17%.

“At 700 basis points – taking the recovery rate to be the long-term average of 40% – the current spread anticipates a total default rate of 43%.”

This is also too high compared to the 12-month default rate forecast for European high yield bonds from Standard & Poor’s – this is between 6.1% (baseline scenario) and 8.4% (worst case scenario).

“The worst case scenario seems unlikely, as companies took advantage of the recovery in 2009 and 2010 to renegotiate their loans and the dates on which the loans were due,” said AGI.

“Of course, a recession could prevent them from respecting the ratios provided for in their loan agreements. But the banks are currently too concerned with their equity to not be flexible regarding disputes, to avoid claims and losses. Nonetheless, market prices anticipate an economic crisis.”

AGI also noted high yield bond offer high spreads, “slightly lower than the spreads seen when Lehman Brothers collapsed, more than three years ago”.

In the eurozone default rates have levelled off at 1.62%, and 2.03% in the United States.

The default rates are also not in line with the volatility of European high yield, AGI said.

The expected default rate of 3% (Moody’s predictions) would correspond to volatility of 30%, compared to the volatility range of the last four months from 18%.

Conversely, the current volatility of 18% suggests a default rate of about 8.5% – about the equal of S&P’s worst case scenario.

“Of course, a market collapse similar to the one in 2008/2009 would trigger a fall in prices. But investors that are able to wait for the market’s return to normal and disappearance of their capital losses would continue to receive a particularly attractive return.

“A decrease in the spread, simply justified by the market’s current volatility, would generate a capital gain of 16%. An additional contraction in spreads towards levels consistent with current expected default rates would generate substantial additional gains.”

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