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KurtShrout

Nine Dynamics of Corporate Bond Default Loss Risk

There are many factors involved in corporate bond default loss risk. Among these factors are (1) default rates , (2) recovery rates, (3) thecyclicality of default rates, (4) the cyclicality of recovery rates, (5)the relationship between credit rating and default rates, (6) therelationship between credit rating and recovery rates, (7) creditrating drift (which varies by starting credit rating), (8) the relationshipbetween holding period and default rates (which varies by startingcredit rating), and (9) the relationship between how senior a bond isand whether or not it is secured and recovery rates. In this article,we will explore these factors.

To see a list of high yielding CDs go here .

Default Rates

To begin with, we should be clearer about what constitutes a default. From what I have seen, the three major credit rating agencies―Standard & Poor’s (S&P), Moody’s, and Fitch―have similar definitions of whatconstitutes a def ault. They all include b ankruptcies, distressed exchanges (and the like, at least in the case of

Moody’s), and missed payments. S&P also includes any “obligor…under regulatory supervision owing to itsfinancial condition” (i.e., issuers rated R by S&P).

Below is a table from the “Fitch U.S. High Yield Default Insight” report covering thru June ‘13. It gives us anunderstanding of how often the different types of default occurred in the last 1½ years. We can deduce that amissed payment can evolve to be a Chapter 11 (bankruptcy) filing, a Chapter 7 (bankruptcy) filing, or a distressedexchange. In a Chapter 7 filing, a company’s assets are liquidated (i.e., sold) to pay its debts―to the extent theycan be paid. In a Chapter 11 filing, a company is rehabilitated via, among other things, easier debt terms and/or partial debt forgiveness. If a Chapte r 11 company cannot be rehabilitated, it may file for Chapter 7.

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Per Moody’s “ Annual Default Study: Corporate Default and Recovery Rates, 1920-2012 ”, from 1994-2012, theaverage dollar-weighted (versus issuer-weighted or issue-weighted) default rate for all rated issuers, on a global

basis, was 1.165% per year. Figures like this are of little use to us though. Default rates vary greatly based uponmultiple factors.

Recovery Rates

Default rate is only one half of the default loss risk equation. The other half of the equation is one minus recoveryrate. The recovery rate is the amount you will not lose, on average, if your bond defaults. Default loss risk equalsthe percentage chance that your bond will default times the amount you will lose in an average default for your bond. When a bond defaults, the loss is usually not 100%.

An average recovery rate is a little less than 40%. Figures like this are of little use to us though. Recovery rates

vary greatly based upon multiple factors. It is important to understand, however, that, if the percentage chancethat your bond will default is 1.165% and the applicable recovery rate is 37.5%, your default loss risk is 0.73%. Itis important to understand the principles involved.

1.165% x (1 – 37.5%) = 0.73%

Default Rate Cyclicality

Default rates vary greatly over time. When there is a recession and more companies are struggling, there aremore defaults. Below is a chart from S&P. The chart is based on issuer-weighted data. Notice that the percentageof defaults is relatively very high in 1991, 2001, and 2009 and relatively very low in 1981, 1996, and 2007.

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The average recovery rate for 2000-2012 shown in the Fitch report was36.5%. The average recovery rate was this low because the years witha higher percentage of defaults had a greater effect on the overallaverage recovery rate. Also, recoveries on junk bonds are a little lower on average than they are on investment-grade bonds, as you will seebelow.

Credit Quality and Default Rate Relationship

Below is another chart from S&P. In the chart, notice the extremelystrong relationship between credit rating and the propensity to default,and that S&P showed no defaults of AAA-or-AA-rated bonds on a globalbasis from 1981-2012. (A D rating indicates a default.) The chart doesnot account for credit rating drift, which is covered later in this article.The chart only reflects a bond’s rating immediately prior to default.

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Credit Quality and Recovery Rate Relationship

Below is a table from the above-mentioned Moody’s report. The table is based on global data. Notice that theaverage recovery rate for investment-grade bonds appears to be about 4% better than the average recovery ratefor junk bonds . When bonds that once had a higher credit rating defaulted, the losses, on average, were not quiteas bad. The early year figures for highly rated bonds are deceptive. The sample sizes are much smaller for thesedata buckets because highly rated bonds rarely default and, when they do, the default usually occurs years later.

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Credit Rating Drift

Credit rating downgrades are more common than credit rating upgrades. Per S&P’s “ 2012 Annual Global Corporate Default Study and Rating Transitions ” report, from 1981-2012, over the course of a calendar year,upgrades occurred 8.48% of the time, downgrades occurred 11.85% of the time, defaults occurred 1.55% of thetime, and withdrawn ratings occurred 7.23% of the time. Counting defaults, upgrades were only 63% as prevalentas downgrades. Not counting defaults, upgrades were only 72% as prevalent as downgrades. Also, per data fromthe above-mentioned Moody’s report, a junk bond is significantly more likely than an investment-grade bond toexperience a rating change, with or without defaults considered.

Below is a simplified version of a table in the above-mentioned S&P report. Notice that, after 10 years, the effectof ratings drift and its downward tendency is rather large. Also notice that, if a bond with a rating at or belowabout BBB does not default, it is more likely to end up with a higher credit rating than it had than it is to end upwith a lower credit rating.

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Below is yet another chart from S&P. In the chart, notice that credit ratings tend to fall significantly prior to adefaults occurring.

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Holding Period and Default Rate Relationship

You may think that, the longer you hold a bond, the more likely it is to default. This is not always true. This is truefor highly rated bonds only. Lowly rated bonds are more prone to default in the early years. Below is a table Icreated based on data in the Moody’s report I mentioned above. There are some data anomalies in the table thatyou should ignore. For instance, AAA bonds are not less likely to default after year 13; and Caa-C bonds are nottotally immune from default in years 18-20. Anomalies like these occur because of limited sample sizes.

In the table, notice that investment-grade bonds are more likely to default as time progresses. This is becausethe bonds have had more time to deteriorate in credit quality due to credit rating drift. Notice that junk bonds areincreasingly less prone to default after year 3. This is because, as stated above, “if a bond with a rating at or below about BBB does not default, it is more likely to end up with a higher credit rating than it had than it is to endup with a lower credit rating”. Notice that the peak year for Caa-C bond defaults is year 1, the peak year for Bbond defaults is year 3, the peak year for Ba bond defaults is year 4―although Ba bonds have a fairly equal riskof defaulting in years 2-19, the peak year for Baa bond defaults is year 16, and the peak year for Aaa-A bonddefaults is year 20. This makes sense because the Caa-C bonds are on the verge of defaulting or relatively closeto it. The other bonds need to migrate downward in credit quality to be highly susceptible to defaulting. The morehighly rated a bond is, the more it needs to migrate downward in credit quality to be highly susceptible to

defaulting.

The All (Rated) figures are somewhat deceptive because junk bonds tend to be much shorter in years-to-maturityin comparison to investment-grade bonds. The later years have a lower percentage of junk bonds and a higher percentage of investment-grade bonds.

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The table above covers the 1970-2012time period and is based on Moody’sglobal data. If you study a different timeperiod and/or use a different data setyou will get results that differ somewhat―even if the data sets usedhave sufficient integrity, which datasets do not always have. One reasonfor this is the default rate cyclicalitydiscussed further above.

Seniority/Security andRecovery Rate Relationship

Average recovery rates vary dependingupon how senior the bond is andwhether the bond is secured or unsecured. Below is a reduced versionof a table in the above-mentionedMoody’s report. In the table, notice thatthe average senior secured bondrecovery rate is much higher than theaverage senior unsecured bondrecovery rate. Also notice that theaverage recovery rate for subordinatedbonds is much lower than the averagerecovery rate for unsubordinatedbonds. Also notice that there is little

difference between the averagerecovery rates for senior subordinatedbonds and (non-senior) subordinatedbonds, but junior subordinated bondshave a much lower average recovery rate than other subordinated bonds .

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””

The data in the table above is based on, with some exceptions, 30-days-post-default trading prices. If you hold adefaulted bond until ultimate recovery (which typically occurs a year or two after default in a bankruptcy), your recovery will probably be a little greater―even after adjusting the ultimate recovery amount for the time value of money.

ConclusionThis article provides good quantification of default loss risk elements, but it does not specifically address the mostimportant question. The most important question is: What default loss risk percentage should I apply inevaluating my specific bond? Your bond has a yield-to-maturity (YTM) or yield-to-worst (YTW). In evaluating thebond, there is a certain percentage you should subtract from the YTM or YTW that represents the averagedefault loss you will experience. Above, using Moody’s 1994-2012 global data, we derived an average defaultloss of about 0.73%; but this figure is for an average bond. It is not applicable to your specific bond. In the nextarticle in this series, we will use the data in this article or similar data to address the most important question.

(Comments are desired, but I do not guarantee their publication. If your comment[s] indicates that you did not read and genuinely consider the all of the article’s contents, I may not publish it; or I may remove it. You do not need to agree; but do not be derogatory. The comment section is meant for legitimate questions or concerns and well-intended discussion. )

About Kurt ShroutKurt has a BA and MA in Communication and over 20 years of business experience, almost always servingas a project or program manager, director, or consultant or as an analyst. He lived and worked in manydifferent locations in the U.S., London, England, and Hong Kong. He has experience in at least 18 differentindustries and 31 different enterprises. Although he was only 49, he essentially retired in 2008 and beganspending a lot more time studying investing. His articles are largely written as a public service. They provide

investors with a rare totally unbiased view of the investing landscape and often include unique analysis. You canread more of his articles by clicking here .

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