Bond default probabilities: by rating

by The Investor on April 9, 2010

When government bond yields are too low to be attractive and investment grade corporate bonds are no longer cheap, ever-greedy investors often look to high-yield (junk) bonds as a way of getting more income for their money.

In early 2010, for example, junk bond sales were at a record high:

Companies worldwide issued $38.3 billion of junk bonds in March, passing the previous high of $36 billion in November 2006, according to data compiled by Bloomberg.

Yields fell 0.95 percentage point to within 5.96 percentage points of government debt, the narrowest gap since January 2008.

Most of that buying will have come from specialist funds and institutions. But plenty of those funds will be driven by private investor demand – and some private investors may also be buying junk bonds directly.

Investing in junk bonds is a dubious idea at the best of times; personally, I think most of us should skip corporate bonds and stick to Government bonds and equities, although that’s hard when Government bond yields are very low.

But certainly, investing in junk bonds when everyone else is doing so has to be a recipe for potential disaster.

Bond default risks are very real

Corporate bonds can and do default. The probability of a bond default is strongly reflected in the credit rating assigned to the bond by the rating agencies.

Non-investment grade bonds – the less scary name for high-yield or junk bonds – have seen pretty high default rates in the past.

This means you should at the least be wary of investing in anything rated by Moody’s or S&P as below Baa/BBB (non-investment grade, in other words).

In practice, it means avoiding buying junk bonds directly unless:

You’re fully fluent in this area.
You have teams of PhDs at your disposal.
You are paid by your employer to manage a junk bond fund.

How often do corporate bonds default?

The probability of a corporate bond default by rating is given in the following table, which is compiled using data from the Municipal Bond Fairness Act of 2008.

While this is U.S. data and municipal bonds (also known as ‘munis’) are a feature of the U.S. market only, the table gives a good indication of the bond default rates in the most liquid corporate bond market in the world.

Cumulative Historic Default Rates (in percent)

	Moody’s		S&P
Rating category	Muni	Corp	Muni	Corp
Aaa/AAA	0.00	0.52	0.00	0.60
Aa/AA	0.06	0.52	0.00	1.50
A/A	0.03	1.29	0.23	2.91
Baa/BBB	0.13	4.64	0.32	10.29
Ba/BB	2.65	19.12	1.74	29.93
B/B	11.86	43.34	8.48	53.72
Caa-C/CCC-C	16.58	69.18	44.81	69.19

Averages
Investment grade	0.07	2.09	0.20	4.14
Non-investment grade	4.29	31.37	7.37	42.35
All	0.10	9.70	0.29	12.98

Source: U.S. Municipal Bond Fairness Act, 2008.

What high bond default rates mean for your strategy

If you’d still like to add non-investment grade bonds to your portfolio to benefit from their higher yield, I’d strongly suggest you avoid buying them directly, given these significant risks of default.

Instead, you are best researching and investing via a High Income fund or investment trust with a manager that specializes in this risky form of debt.

As mentioned above, for my part I’ve been persuaded by Yale portfolio manager David Swenson and others that chasing the extra yield from junk bonds isn’t worth the risk.

This is especially true given that investing via a fund or trust (the only way I’d put money into high-yield bonds) means paying high management charges (and potentially performance fees) that will reduce your returns.

1 Evan April 9, 2010, 4:41 pm

Maybe you can help me out Monevator, since the crash/correction whatever you want to call it of the financial sector and the market as a whole as a result…why does anyone still listen to rating agencies. Didn’t they still have lehman and gm bonds at AA rating (or equivilent) prior to their bankruptcies?

Is it because they are the only option?
.-= Evan on: What is Keyman Insurance? Is Your Business Protected From Death? =-.
2 The Investor April 9, 2010, 5:27 pm

Well, for disclaimer – I’m not an expert! And also I’m not sure what the status was of those bonds to be honest Evan.

In general, I’d say that the ratings agencies are taking a lot of excess flack, because it’s in the interests of all the really rich and/or powerful incumbents to blame them (e.g. the big banks, the big hedge funds, the politicians, etc). There’s a bit of messenger blaming going on.

For instance in the case of mortgage backed securities, banks that created opaque securities and passed them can’t really blame the ratings agencies for not properly seeing into them.

Even on that note, it’s debatable that the ratings agencies utterly ‘failed’. In the credit crisis, and especially around the time of the Lehman’s collapse, the entire market simply stopped. Securities that could be bought for insane haircuts – say 30 cents on the dollar – could not as I understand it be moved or bought by anyone with sufficient money to make a difference (which was exactly why those prices had fallen so far). Highly-rated paper crashed in value, but a lot of it hasn’t actually defaulted even now.

This freeze-up brought down companies like Lehman’s and Northern Rock here in the UK, but arguably an utterly dead market wasn’t a circumstance the ratings agencies can reasonably be expected to rate for. That’s a bit like asking your estate agent to value your property in the event of World War 3 and bombers overhead! 😉

Sure the ratings agencies aren’t perfect, and yes the obvious conflicts of interest need to be stamped out and regulated against, but I’m always suspicious when the big rich guys blame the smaller, unloved guys.
3 The Investor April 9, 2010, 5:28 pm

p.s. The nature of ratings in some ways is to tend towards wrongness. E.g. If you rate something triple A, there’s only one way it can go, and it will go down by more steps of your current rating being wrong. It’s the nature of the beast. (Of course, company debt *can* be uprated, too, but nobody complains when that happens!)

p.p.s. Just look at the pressure the agencies are under over Greece’s debt, or even not to de-rate the securities of the US or the UK right now…
4 Niklas Smith April 9, 2010, 5:30 pm

@Evan: I agree that ratings agencies have a lot to answer for (and in my opinion they have got off lightly). But the worst examples of optimisic (or loony) ratings were of structured debt products like CDOs, where the agencies had little understanding how vulnerable they were to defaults of the original loans (then again, neither did those who sold them!).

To my knowledge they have still be reasonably good at predicting the likelihood of default on corporate bonds, which are orders of magnitude simpler.
5 Niklas Smith April 9, 2010, 5:37 pm

@Monvator: Sorry, you replied while I was writing!

Actually, I haven’t seen the ratings agencies taking much flak (certainly not compared with the bankers, who deserve it, and the hedge funds, who don’t). My impression is that they have got away remarkably cleanly. Remember also that they are the powerful institutions here – the “market” for credit ratings of major companies and governments is essentially a duopoly, thanks to a great degree to government regulations that favour their ratings.

In one chapter of his excellent book on the crisis, Johan Norberg rather demolishes the ratings agencies. In some cases it is clear that the conflict of interest inherent in the way ratings are paid for resulted in misleading ratings being knowingly given: http://www.amazon.co.uk/Financial-Fiasco-Americas-Infatuation-Ownership/dp/1935308130/

See for example the quote Giles Wilkes republishes here: http://freethinkingeconomist.com/2009/12/07/in-which-i-admit-being-wrong-to-paul-cotterill-who-was-right/
6 The Investor April 9, 2010, 6:04 pm

@Niklas – Will definitely read those links, as I want to know more. Perhaps my view of the ratings agencies getting blamed is based on the unfortunate CNBC habit I’ve developed. (Theoretically I watch it ‘for a laugh’… 😉 ). Every other speaker on there was kicking the ratings agencies at one point.

Agree they haven’t suffered much materially, but who has apart from the banks that went bust and a few CEOs? Even the bankers don’t seem to be doing too badly on their enforced diet of higher capital ratios given all the conveniently cheap money about to fund it.

Absolutely right about MBS, and also about corporate bonds where they have decades of experience (though they can and are ‘wrong’, if subsequent de-ratings are a reflection of wrongness… but as I say it’s the nature of the business).
7 Financial Samurai April 12, 2010, 5:08 am

Gotta say, I think rating agencies are the biggest load of crap. They always downgrade AFTER something goes wrong. Pretty useless those folks. However, the agencies due keep keep people employed which is great!
.-= Financial Samurai on: Wealth Is An Illusion Of Happiness =-.
8 The Investor April 12, 2010, 12:52 pm

I strongly suspect ratings agencies don’t only downgrade *after* the event. They rate thousands of securities. I expect we only here about the bad calls.

Also, as I said above downgrading is in the nature of the ratings business.

They can’t be super-investors who can always see what can happen to a company in the future. (Or if they can, they should leave the ratings industry and run hedge funds).

What they can do is give a useful indication of riskiness, and I think they do this well with corporate bonds.
9 Robert Wasilewski April 23, 2010, 11:19 pm

I agree with your comments on timing. Now is not a good time to invest in junk because spreads are so tight.
I also agree that investors should consider funds – actually ETFs.
But the sector is worth considering for up tpo 10% of a portfolio when spreads are at more normal levels.
The iShares ETF with ticker HYG returned 3.67% annually over past 3 years – a nice counter to the -4.56% return of the S&P 500! And its expense ratio was .50%.
.-= Robert Wasilewski on: DIY Investor Newbie – Risk Tolerance (Cont.) =-.