The incremental compensation received by an investor for purchasing a bond issued by a corporation instead of a sovereign is known as the credit spread. What exactly is the investor being compensated for? Credit investors assume interest rate, liquidity, reinvestment, call, and inflation risks. Today, we focus on one of the most critical challenges a credit investor faces, default risk.

Understanding Default Risk

Default risk represents the risk a bond issuer fails to make interest or principal payments. The weaker the credit quality of an issuer the greater the default risk. High-yield bond holders assume more default risk compared to investment-grade bond buyers, the lower the credit quality the greater the risk.

There are two components of default risk:

1. Probability of Default: Measures the likelihood an issuer will default. The first key output of Mawer’s proprietary research process is a Mawer Credit Rating. The Mawer Credit Rating corresponds to an historical default rate.
   
   
2. Loss Given Default: Estimates the loss incurred by an investor in a default scenario. Mawer Margin of Safety is the second key output of our proprietary research process. The methodology probability weights scenarios incorporating aggregate historic default and recovery rates, as well as industry specific examples.
   
   The Credit Suisse acquisition by UBS in early 2023 is an industry example. Credit Suisse’s AT1 investors experienced a 100% loss, while UBS assumed the senior and subordinated debt obligations of Credit Suisse. The default and recovery rates from this example factor into our bank Margin of Safety calculations.

The Data Behind Default Risk

According to JPMorgan the long-term default and recovery rates of the high-yield credit market (comprised of loans, bonds, and distressed exchanges) average 3.1% and 39% respectively (on average investors lose 61% of loan par value in a default scenario).

Multiplying average default rates by average recovery rates, derives a base rate of default risk. An investor with a 100% high yield portfolio will, on average, experience a capital impairment of approximately 1.9% annually (3.1% default rate X 61% capital loss) due to default risk.

Current Default Trends and Compensation

How does the current default environment compare? In 2024, the default rate at 3.0% was consistent with historical trends, with average recoveries of 35%. However, current high-yield spreads of 303 basis points are 250 basis points below the long-term average. It is clear the compensation investors receive for taking on default risk today is significantly lower than historical. Caution is warranted.

The Non-Linear Nature of Defaults

Defaults are discrete and not linear. While the long-term average default rate is 3.1%, certain years —e.g., 2009 and 2020—saw default rates spike much higher. Further, research shows recovery rates typically decline in years with elevated default rates. So in a rising default environment, recovery rates can fall, a potential double whammy for investors.

Mawer’s Approach to Managing Default Risk

We do not manage the Mawer Global Credit Opportunities strategy with a top-down approach, nor do we attempt to predict defaults and recovery rates across the entire high-yield universe. Instead, the strategy’s credit quality and resultant default risk is the sum of individual credit decisions made through our bottom-up, fundamental analysis process.

Aggregate historical default and recovery rates combined with current market trends are important and interesting. That said, the primary focus of our process surrounds understanding both components of default risk for individual issuers as reflected in our Mawer Credit Rating and Margin of Safety analysis.

Our goal is not to shy away from default risk but to ensure investors are appropriately compensated for it. By leveraging historical data into our rigorous process, we make informed investment decisions aligning our risk management principles and long-term objectives.

Understanding the probability and economic ramifications of an issuer defaulting is key to successfully navigating the complexities of credit investing.

- Mawer Credit Team