Recent (1978–83) net returns on high-yield, low-rated debt have been impressive, averaging 490 to 580 basis points above the long-term government bond index. But low-rated “junk” bonds pose a risk of default not present in the higher-rated segment of the bond market.
The authors divided the par value of defaulting debt by total low-rated straight debt outstanding to arrive at an estimate of the default rate for high-yield bonds (excluding Johns Manville, which had the only defaulting debt rated investment grade just prior to the default date). For the 1974–84 period, this averaged 1.52 per cent (or 152 basis points) annually. Year-to-year variations in the rate were substantial. Furthermore, default experience differed across various industry segments. Railroads and REITs were particularly vulnerable to default in the past, although they are unlikely to represent a large portion of future defaults. Retailer, electronic/computer, airline, and oil and gas defaults have become more common in recent years.
Losses from default are actually lower than the default rate alone implies. Defaulted bonds traded, on average, at 41 per cent of par shortly after default. After accounting for the bonds’ retained value and the loss of interest, the average reduction in return to the investor who had purchased the bonds at par would have been in the range of 96 to 100 basis points annually.
