For investors in risky high-yield bonds – also known as junk bonds – the rate at which companies default on their debts is a crucial factor in determining how good their returns are.
A sudden spike in defaults can wipe out years of gains. But recent years have seen an exceptionally benign environment for high-yield investors, as this chart from Deutsche Bank shows. Default rates on bonds with a credit rating of B (the middle of the scale for junk-bond ratings) have averaged just 1.5% per year over the past 12 years, compared to an average of 6.9% from 1983 to 2002.
This lower default rate is largely due to low interest rates and rising demand for income, which has allowed poor-quality companies to borrow at cheap – and hence more affordable – rates. When interest rates finally start to rise, defaults are likely to pick up, with serious consequences for many investors in these bonds.