Digital Nugget: Crypto yield trumps high-yield debt

The yields available in the crypto market offer higher returns with lower risk than high-yield bonds. In this article, we compare the relative risks.

The relatively high interest rates available in crypto lending draw comparisons with high-yield bonds. The yields available in the crypto market often exceed the yields on junk bonds, and in some cases significantly.

If risk was priced efficiently across the two markets, we would expect to see correspondingly higher risks in crypto lending. Instead, we find the opposite to be the case.

Comparing the returns

BB-rated bonds have been yielding between 3 to 5 percent over the last two years, increasing to 5.3 percent recently. CCC-rated bonds are trading at 10.3 percent, having increased from 6.5 to 7 percent a year ago. There are no similar indices for crypto yields at this point, and the available yields vary greatly between tokens and platforms, and over time. However, the yields offered are on average broadly comparable to those of junk bonds, and in some cases, they are much higher.

Funds that invest in crypto yield seek out the highest-yielding opportunities and rotate the positions as supply, demand and incentives change over time.

Unlike bonds, crypto yields are short-term de facto “money market” yields and do not bear price risk. Rising yields meant that there were only three US high-yield bond mutual funds that generated returns higher than 5 percent over the past year (with the highest return at 10.57 percent) while most crypto yield funds have generated returns between 10 and 30 percent.

Comparing the risk

The fair credit spread on bonds is a function of the probability of default and the recovery rate.

As crypto lending is over-collateralised at this stage, the greatest risks investors bear are related to the security of the platforms they use – bugs, hacks and other exploits.

The average annual default rates for high-yield debt range from 1.2 percent for BB bonds to 5.23 percent for B and 19.47 percent for CCC bonds and below, according to Moody’s. S&P quotes 3.75 percent as an average for all below-investment-grade bonds.

The equivalent metric for crypto yield is the rate of funds lost to hacks, bugs and exit scams in the decentralised finance (DeFi) sector. The chart below shows the summary of funds lost and the number of incidents per quarter.

There is some disagreement as to which incidents should be included. We excluded the incidents related to gaming platforms such as Vulcan Forged or Ronin/Axie Infinity, as these are unrelated to crypto yield generation in the decentralised finance space. We included hacks of blockchain interoperability protocols such as the Poly Network or Wormhole with a dotted line, as these were also not specifically DeFi platforms although they are related to DeFi activity.

We compared the amounts lost to hacks and similar incidents to the total value locked on DeFi platforms. As the DeFi sector grew and gained popularity in 2020, the annualised rate of losses was 1.54 percent. As the sector matured, the “default” rate fell to 1.15 percent by 2021 (1.65 percent, if we also include the interoperability protocols). This year, the proxy “default” rate has fallen further to 0.44 percent if we annualise the Q1 rate of hacks (1 percent including interoperability protocol hacks).

The chart also shows that the number of hacks declined to 24 by Q1 2022, after peaking at 40 in Q3 2021, although the average size of the funds involved has been generally increasing in line with the growth of the DeFi sector and the crypto market in general.

Further review of these activities gave a better overview of the developments:

• In 2020, when the DeFi sector was still nascent, the rate of hacks (1.54 percent) was already lower than the default rate of B bonds at 5.23 percent, much lower than the CCC and even further below rate bonds’ default rate of 19.47 percent
• By Q1 of 2022, the rate of hacks declined to 0.44 percent (or 1 percent, if we use a generous definition of a DeFi hack), below those of BB bonds at 1.2 percent
• The rate of hacks puts the risk of crypto yield somewhere between the risk of BB and BBB bonds with historic default rates of 1.2 percent and 0.26 percent, respectively

Comparing actual losses

The picture looks even more favourable if we compare the amounts that investors lost.

In the case of high-yield debt, this is determined by the recovery rate, which has a historic average of around 40 percent (according to Moody’s), i.e. 60 percent of the defaulted amounts were lost.

DeFi hacks, even if we assume 100 percent of the funds lost, have a rate of loss that is below the actual losses for high-yield bonds, which averaged 2.25 percent (60 percent multiplied by 3.75 percent).

But in several cases, the losses were fully covered by the protocols involved, or the company (if any) behind them. In many cases, the hackers were tracked, and the funds were returned.

We conservatively estimate that at least half of the funds lost have been recouped.

In the case of the two large interoperability protocol hacks (Wormhole with USD 326 million and Poly Network with USD 611 million), users were made whole (Wormhole), or the funds were returned (Poly Network).

Some of the hacks did not affect users of the protocols, for example in the case of Compound’s two consecutive exploits of USD 80 million and USD 68.8 million, hackers tricked the protocol to distribute additional rewards to them in the form of Compound tokens. The users of the Compound lending platform were not affected.

Summary

Crypto yields offer better value than the high-yield debt market. Their risk level lies somewhere between the weakest investment grade and the strongest junk debt, while their returns exceed those. The short duration is a further advantage.

There are a few reasons for the better risk/reward:

• Traditional credit markets are overvalued due to the large amounts of liquidity provided by central banks
• Temporary incentives provided by DeFi protocols are attracting users
• Alpha is available in the crypto yield markets

Although the alpha may erode over time, as larger pools of funds access these returns, crypto yield funds currently have a significant edge over high-yield and alternative debt funds.

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