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Federal Reserve Bank of Boston
Working Papers
Defaults of original issue high-yield convertible bonds
Eric S. Rosengren
Abstract

The success in marketing original issue high-yield bonds has generated significant interest in their default experience. Studies comparing defaults to the par value of outstanding issues such as Altman (1987), Altman and Nammacher (1985), and Weinstein (1987) have found relatively low default rates. However, these studies understate default rates because of the rapid increase in the par value of outstanding issues and because cumulative default rates increase with years from issuance. Two recent studies by Altman (1989) and Asquith, Mullins and Wolff (AMW) (1989) have corrected these problems by using aging analysis to follow rated nonconvertible high-yield bonds over time; they find cumulative default rates for such bonds 10 years after issuance exceeding 30 percent. ; This study extends the literature on high-yield default rates to convertible and nonrated securities, not examined in previous studies. The high-yield market can be partitioned into rated nonconvertible, rated convertible, nonrated nonconvertible, and nonrated convertible securities. Other things equal, one would expect higher default risk to be associated with higher yields; however, other things are not equal. For example, securities may have high yields because of differences in liquidity or differences in conversion options. Therefore, yields reflect more than just expected default risk; they also incorporate premiums for other characteristics of individual securities. ; When the securities are partitioned by rating and convertibility, the results of this paper show that the cumulative default rates are lower for rated convertible securities than for rated nonconvertible securities. Because investors value convertibility, convertible bonds carry substantially lower coupon rates than nonconvertible bonds. These lower coupon rates may reduce the likelihood of an issue defaulting. ; In addition, this study examines nonrated securities. Many securities are nonrated because the graduated fee structure charged by rating agencies makes ratings prohibitively expensive for smaller issues. Despite some potential biases that are discussed below, the default rate on nonrated convertible bonds is significantly less than that of rated nonconvertible securities, and the default rate on nonrated nonconvertible bonds appears to be less than that for rated nonconvertible securities. ; The next section of the paper discusses the data and shows that the default rates for rated nonconvertible securities are higher than those for rated convertible, nonrated convertible, and nonrated nonconvertible securities. Each category of security is further examined for explanations for lower default rates, in Sections II through IV. Section V estimates a logit model that shows that default differences based on security characteristics persist even after controlling for coupon rates and size. Section VI summarizes the results.


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Eric S. Rosengren, Defaults of original issue high-yield convertible bonds, Federal Reserve Bank of Boston, Working Papers 92-6, 1992.
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Keywords: Bonds ; Corporate bonds
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