Default Rates and Bonds
The 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, investment-grade corporate, high-yield, and emerging market bonds, but it isn’t relevant for U.S. Treasuries since there is virtually no 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 generally relatively rare occurrences for the highest-rated securities -- premier rating agency Standard & Poor's 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, this resource provides some insight into the likelihood of default for 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, but some notable takeaways are:
- 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%.
- 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 4.28%, but for the lowest tier, CCC/C, the default rate was 26.85%.
- By a wide margin, the majority of defaults are preceded by downgrades to the issuer’s credit rating.
- Municipal bonds also have exhibited a low default rate, and as was the case in the corporate sector, most of the defaults occurred among the lowest-rated securities in the sector. According to Fmsbonds.inc., “Of the bonds that did default, the major cause, according to Moody’s, was ‘enterprise risk.’ This risk results from a failure of a bond-financed project to achieve its projected results due to faulty planning or economic downturn, rendering a project unfeasible.”
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.