High-yield investors should take little comfort from a low default rate (with most forecasting for that to continue), says Martin Fridson, reminding the default rate in 2007 was 0.975%, but junk suffered a 5.6% price drop that year.
The commonly held belief that high-yield total return equals yield minus default loss is "essentially irrelevant over a one-year horizon" in that it assumes the bonds which default in any given year began the year at par. In truth, the vast majority of any year's defaults began the year as distressed paper with spreads to Treasurys of 1K basis points or more.
"Investors are ill-served by overly simplistic analysis implying that mid-double-digit returns are a sure thing as long as the default rate remains below average. The high-yield market has proven that it is quite capable of generating substantial price declines even in the face of extremely low default rates and declining Treasury yields."
Yesterday: Junk-bond default rate slides to just 1.6%.