Default Rates and Bonds
Bonds are securities that are issued by corporations and governments to fund operations and programs. Governments sometimes default on their loans, and it is not unheard of for corporations to do so as well. Many factors cause corporations and governments to default on their payments, and, when many corporations default, a measurement can be taken and compared to global circumstances to shed light on these causes.
The corporate default rate measures the percentage of issuers in a given fixed-income asset class that failed to make scheduled interest or principal payments in the prior 12 months. For example, if an asset class had 100 individual issuers and two of them defaulted in the prior 12 months, the default rate would be 2%. The default rate can also be dollar-weighted, meaning that it measures the dollar value of defaults as a percentage of the overall market.
The Implications of Bond Default Rates
Naturally, a high or rising default rate is a negative factor in the performance of an asset category, while a low or falling default rate helps support performance. Default rates tend to be highest during periods of economic stress, and lowest during times when the economy is strong.
The default rate is a consideration for investors in municipal, high-yield, emerging market, and investment-grade corporate bonds. The bond default rate isn’t relevant for U.S. Treasuries since there is a nominal chance that the federal government will default on its debt; in more than 200 years, it never has.
The Incidence of Bond Defaults
While a default is a catastrophic event for the price of an individual bond, defaults are relatively rare occurrences for the highest-rated securities. Premier rating agency Standard & Poor's (S&Ps) historical data on corporate and high yield default rates are perhaps the greatest primer for proving their stability.
Containing a treasure trove of data dating back to 1981, the S&P resource provides some insights into the likelihood of a default in investment-grade and high-yield (otherwise known as "junk") bonds. It’s worth taking a moment to scan the charts and tables to learn more about defaults; there are some notable takeaways.
Default rates have been quite low in the corporate bond market over time, averaging 1.47% of all outstanding issues in the 32-year period measured. Investment-grade bonds defaulted at a rate of just 0.10% per year, while the default rate for below-investment-grade (high-yield) bonds was 4.22%.
Low Rated Bond Default Rate
The vast majority of defaults have occurred among the lowest-rated issuers. The 31-year average for securities rated AAA (the highest rating) and AA were 0.0% and 0.2%, respectively. Comparatively, the default rate among B-rated issuers (the second-lowest) was 3.44%, but for the lowest tier, CCC/C, the default rate was 26.63%.
By a wide margin, the majority of defaults are preceded by downgrades in the bond issuer’s credit rating.
Municipal Bond Default Rate
Municipal bonds also have exhibited a low default rate, and, as the corporate bond default rate demonstrates, most of the defaults occurred among the lowest-rated securities in the sector.
As an investment, municipal bonds do come with some risk. This risk is generally the result of an endeavor that is financed by bonds to make it to completion—due to economic downswings or an improperly planned and managed project.
Avoiding Bond Defaults
From this survey of the bond market, it’s evident that investors can largely limit their exposure to default by investing in AAA- or AA-rated bonds or in bond funds that concentrate on these higher-rated securities. Even so, an investor who holds bonds or bond funds that completely avoid defaults are still subject to interest rate risk and therefore not immune to loss of principal if sold before maturity.