Bonds are securities that are issued by firms and governments to fund projects and programs. While it is not common for cities, states, and countries to default on their loans, it does happen. Further, it is not unheard of for firms to do so as well. Many factors cause corporations and governments to default on their payments. When firms default on debt, it can be helpful to look at the rate of default to glean insight into how bonds will do.
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 instance, if an asset class had 100 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. This means the dollar value of defaults is measured as a percentage of the overall market.
- The bond default rate is vital to weight if you're putting your money toward municipal, high-yield, emerging market, or investment-grade corporate bonds.
- Defaults are fairly rare for highly rated securities.
- Use Standard & Poor's ratings to find bonds that are highly rated.
The Outcomes of Bond Default Rates
A high or rising default rate is a minus factor in how well an asset category does. A low or falling default rate helps support performance. Default rates tend to be highest during times of economic stress and lowest during times when the economy is strong.
Investors in municipal, high-yield, emerging market, and investment-grade corporate bonds look closely at the default rate. Still, the bond default rate isn't relevant for U.S. Treasury bonds since there is a low chance that the U.S. will default on its debt. In more than 200 years, it never has.
How Often Do Bond Defaults Happen?
While a default causes damage for the price of a bond, defaults rarely happen for the highest-rated securities. The premier rating outlet Standard & Poor's (S&Ps) historical data on corporate and high yield default rates are perhaps the greatest primer for proving their stability.
The S&P contains a treasure trove of data dating back to 1981, and this 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. By contrast, the default rate among B-rated issuers (the second-lowest) was 3.44%. For the lowest tier, CCC/C, the default rate was 26.63%.
By a wide margin, the majority of defaults happen after a downgrade of the bond issuer's credit rating.
Muni Bond Default Rate
Muni bonds have also shown a low default rate. As the corporate bond default rate shows, most of the defaults occurred among the lowest-rated securities in the sector.
As an investment, muni bonds do come with some risk. This risk is most often the result of a project that is financed by bonds. The default may come due to a sudden economic crash or a poorly planned project.
Avoiding Bond Defaults
When taking a close look at the bond market, it's clear that those who invest in it can largely limit their risk to default by investing in AAA- or AA-rated bonds. They can also invest in bond funds that focus on securities with high ratings. Even so, an investor who holds bonds or bond funds that do not default can still be subject to interest rate risk and therefore not immune to loss of principal if sold before the bonds mature.