Don't fear credit defaults
Investors are often frightened away from European high yield credit by fears of company defaults. That’s ironic on several counts.
First, the very possibility of default is why high yield credit offers premium yield. In fact, our research shows that this premium has historically exceeded default-driven losses by a significant margin.
Second, those same investors are often happy holding equities, even though they too experience default-like episodes that are more both more frequent and severe than they are in credit.
And third, European high yield bonds have, over the long run, typically delivered a better risk-reward profile with lower volatility, smaller drawdowns and higher returns than European equities.
Compensated for risk
Since the turn of the millennium, European high yield credit had an average annual default rate of 1.3% corresponding to an annual average performance loss of 0.70%. But investors were more than sufficiently compensated for taking on that default risk. Over the same period, European high yield credit generated an annualised return of 5.2%, compared to 2.8% for the safe alternative, German government bonds.
More significantly, they also outstripped the riskier alternative – European equities generated an average annual return of just 4.1%.1
European high yield credit’s relative performance looks even better on a risk-adjusted basis. Annualised volatility was just 10.7% compared with 18.2% for equities, while the maximum drawdown was 37% compared with 55% for stocks.
Those relative drawdowns tilt even further to credit’s favour when the subsequent market rebound is taken into account. High yield credit has tended to broadly match –or beat – equities in the six months following a market bottom, while also extending gains over the subsequent year. There are two factors that tend to propel credit in such situations that equities lack: coupons and the pull to parity. Unlike dividends, which can be cut and not reinstated, short of a default, bonds deliver yield. As for the second factor, the fact that bonds are redeemed at par – which is to say at face value – as they mature, their prices will tend to converge to par, therefore rising if they have been beaten down to a discount.
| German Government | EUR Investment grade | EUR High yield | EUR Equities | |
| Return Annualized | 2.8% | 3.5% | 5.2% | 4.1% |
| Volatility Annualized | 4.6% | 4.1% | 10.7% | 18.2% |
| Sharpe Ratio | 0.61 | 0.86 | 0.49 | 0.22 |
| Maximum Drawdown | -22% | -17% | -37% | -55% |
Better by default
Less obvious but no less important, few investors realise is that equities also suffer what are in effect ‘defaults’ and they do so at a considerably greater rate than high yield credit. Although strictly speaking equities don’t default – though companies do go bust – to create a comparative, we take as a proxy the fact that recovery rate2 on high yield credit has been some 30%. So we consider stocks that have fallen in price by 70% a starting point for equity defaults. We further narrow the definition to stocks that have dropped out of the MSCI Europe equity index. Using that as our metric for equity defaults we then compare these to standard definition of credit default (covenant breaches, failure to pay coupons etc).
We find that since 2005, the average annual default rate on European high yield credit was 2.35%. By comparison, the equity default rate was 5.17%. By our definition, a higher proportion of equities defaulted every year except in 2024, when the equity and high yield default rates were broadly similar.
Default lines
European default rates 2005-2024, equities and credit
Default rate in European credit is the face value weighted index default rate, where defaults capture bankruptcies, missed payments and distressed exchanges. Indices are ICE BofA European credit indices. Default rate in European equities is the total weight of companies having been removed from the index after a drop of at least 70% from peak values. Source: ICE BofA (defaults = index defaults), MSCI (defaults = 70% equity drop), Pictet Asset Management.
Results elsewhere are similar, with high yield registering better risk to reward profiles than equities and substantial uplift in returns on sovereign debt even when accounting for defaults. The benefits are clear for investors willing to take a medium- to long-term approach to the asset class, rather than use it purely as a short-term tactical allocation.
Investors tend to be so heavily focused on credit’s default risks that they miss essential context. Yes, high yield credit defaults. But investors are well paid for taking on that risk, not least relative to so-called risk-free assets like sovereign debt. At the same time, investors miss the fact that they also face what are in-effect higher default rates in equities, assets that aren’t nearly as generous in compensating for default risks. High yield’s lower default rate, combined with its higher average returns, lower volatility, smaller drawdowns, and stronger recovery post-drawdown further reinforce the asset class’s attractiveness relative to equities.
Our numbers should make investors reconsider their unease about default rates. The opportunities high yield offers shouldn’t be clouded by misperceptions about the risks.