Hooks in the record books

A triple-C rating (CCC) is known as “the hooks” in junk bond parlance. Sounds a bit better than Moodys who define them: “…to be of poor standing and are subject to very high credit risk”. Despite that definition they have been doing very well over the last couple of years and yesterday the average spread on European bonds rated CCC & below reached 359 basis points, the lowest on record. To put this in perspective, CCC spreads reached a peak of 3845 basis points on 1st October 2001 (yes, that’s a 38.45% excess yield over government bonds). It’s the same story in the US, where spreads on bonds rated CCC & below now stand at 452 basis points, also a record low. This is important because US spread history for the poorest rated bonds goes back to 1988, whereas European high yield data is only available from 1998.

Are CCC rated bonds compensating us enough for default risk? Based on historical default rates, the answer is a resounding “no”. Moody’s most recent annual default study looks at global default data from 1920-2005, and on a five year moving average, the historical global default rate for CCC rated bonds is a rather worrying 29.7%. So, if you bought a CCC rated bond now, based on an historical default rate, there is almost a 1 in 3 chance that the bond you bought would default over a five year period.

It’s all very well looking at historical averages, but are we in an “historically average” credit environment right now? Again, definitely not. The global economy had one of its strongest years ever in 2006, which goes a long way to explaining why defaults have remained so low. In Europe, following the default of Schefenacker, only 2 out of 155 companies’ bonds are trading at distressed levels (ie yielding 10% more than government bonds) indicating that they are likely to default soon.

Even though balance sheets are generally very healthy and the credit environment is very supportive, it is difficult to be bullish on something that is the most expensive it has ever been. In my funds I am being cautious on triple-Cs. Where I do hold them it is because they have short maturities or we think that they are likely to be refinanced. I’m not hooked

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

David Fancourt

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