Defaults and Returns on High Yield Bonds: The Year 2002 in Review and the Market Outlook

Abstract

The year 2002 was remarkably difficult on many fronts for most financial markets. For the high yield bond market, it was again a year of record amounts of defaults which contributed to low recovery rates and slightly negative absolute returns. The default rate registered a massive 12.8%, based on $757 billion outstanding. Despite these record default totals and rates, the market’s decline was orderly with little panic and actually ended the year with reduced defaults and highly positive returns in the fourth quarter.

Default amounts registered its fourth consecutive record year and almost topped $100 billion ($97.9 billion) for the first time. This total was more than 52% higher than last year’s record. Combined with a near record low recovery rate of 25 cents on the dollar, weighed down by Telecom’s average recovery rate of 16%, loss rates from defaults reached record levels of about 10% -- even adjusted for fallen angel default recoveries. The pervasive influence of WorldCom’s massive default had a profound effect on both the default and recovery rates. Without WorldCom, the year’s default rate would have been 9.27% -- a differential of about 3.5%.

This report documents and comments upon the high yield bond market’s risk and return performance over the period 1971-2002. We will present traditional, dollar-denominated default rates as well as our own mortality rate statistics. Default rate analysis will be complemented by discussion on corporate bankruptcies and the immense impact of fallen angels on the high yield market. We conclude with our annual estimate of the size of the distressed debt market and our forecast for defaults in 2003. Our analysis will include an update on our default recovery forecasting model which was extremely accurate in estimating 2002’s recovery rate of about 25%.

Based on the fourth quarter’s reduction in default rate to 1.82% and our aging-mortality conceptual framework, we are predicting a reduction in the dollar denominated default rate to 7.5-8.0%, as much as 5% less than 2002 (but still far above the average rate). This should help provide a more attractive environment for high yield debt new issues and returns in 2003.

In 2002, there was $65.6 billion in new high yield bond issuance, down from 2001’s $88.2 billion. We expect new issuance in 2003 to escalate unless the economic/political scene motivates another flight to quality in our financial markets.