TAILIEUCHUNG - Understanding Aggregate Default Rates of High Yield Bonds

The market for high yield or speculative-grade bonds1 has grown from $30 billion of outstanding bonds in 1980 to nearly $250 billion today. Over this period, the market has evolved from a collection of “fallen angels”—bonds that have lost their investment-grade rating—into an established capital market for raising funds. Although the high yield market is now mature, its behavior during business cycle downturns is not well understood. During the severe recessions of 1980-82, when the market was in its infancy, few issuers of speculative bonds defaulted on their obligations to creditors. By contrast, in the mild recession of 1990-91, the default rate soared to 11 percent. These sharply divergent experiences raise the question:. | FEDERAL RESERVE BANK OF NEW YORK May 1996 Volume 2 Number 6 Understanding Aggregate Default Rates of High Yield Bonds Jean Helwege and Paul Kleiman What explains the wide swings in the default rate on high yield bonds in recent years Differences in credit quality from year to year account for much of the observed variation in default rates but economic conditions and the age of bonds have also played a role. The market for high yield or speculative-grade bonds1 has grown from 30 billion of outstanding bonds in 1980 to nearly 250 billion today. Over this period the market has evolved from a collection of fallen angels bonds that have lost their investment-grade rating into an established capital market for raising funds. Although the high yield market is now mature its behavior during business cycle downturns is not well understood. During the severe recessions of 1980-82 when the market was in its infancy few issuers of speculative bonds defaulted on their obligations to creditors. By contrast in the mild recession of 1990-91 the default rate soared to 11 percent. These sharply divergent experiences raise the question How does the high yield market typically respond to a slowing economy To understand the effects of recessions on default rates we must first understand what causes the default rate to vary over time. This article explores the factors that help explain the past history of the aggregate high yield default rate. To begin our analysis we consider existing statistical models that attribute variation in the default rate to changes in credit quality macroeconomic conditions and the age of bonds. We then build on this earlier work by clarifying the relative importance of each of the factors in the models and by refining the measures used. Explaining Aggregate Default Rates The fraction of all high yield issuers defaulting in a given year has fluctuated greatly in the recent past. Since 1981 the aggregate default rate averaged just under 4 percent but the .

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