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S&P default rate report shows the value of investment grade

by Gavin Madson | Apr 16, 2013

Standard & Poor’s last week released their 2012 Annual Asia-Pacific Corporate Default Study and Ratings Transitions report. This report reviews all rating activity undertaken by the agency across the region including monitoring defaults as well as rating movements (upgrades and downgrades). The week prior, the rating agency released its global version of the report.

In 2012 there were a total of 84 defaults in the S&P global universe (of around 6,000 ratings), none of which were rated ‘investment grade’ (BBB- or better). There were no defaults recorded in Australia and only five in the Asia-Pacific region (two from China and one each from Indonesia, India and Japan).

Defaults increased from 2011 (where 53 were recorded) reflecting the deteriorating conditions particularly being felt in peripheral Europe. We note however that markets continue to recover post the global financial crisis where defaults hit an all time peak of 265 in 2009 (see Figure 1 below). The study, which goes back over 30 years demonstrates the cyclical nature of markets as shown in the graph where there are distinct peaks in defaults which align with the GFC in 2009, the recession surrounding the ‘tech-wreck’ in 2001 and the recession a decade earlier in 1991.

Figure 1

This 10 year cycle, which coincides with global or large scale recessions, highlights our persistent theme here at FIIG for the need for portfolio asset diversification. Each of these default peaks corresponded to significant drops in equity prices. Whilst the peak of defaults was 2009 with 265 rated defaults, 14 defaults is the peak of global investment grade defaults – from a sample of over 3000. For investors looking to protect their capital, investing in investment grade bonds is shown to be a statistically safe way to diversify holdings and recession proof investments.

Investment grade stacks up over the life of the study

Whilst this makes for good reading for the 2012 year for investment grade market, the statistics over the 30 year study period also give confidence to investors in highly rated bonds.

Table 1

The cumulative default rates in Table 1 show the lowest investment grade ratings (BBB-category) cumulative default is only 4.59% over a 10 year period. Default rates step up considerably once you move down to sub-investment grade with a 10 year cumulative default rate of 15.09% for BB rated companies. The majority of defaults globally were recorded in the U.S. reflecting their bond market which is the broadest and most mature of any of the global bond markets and the decision of the Fed to maintain extremely low yields on Treasury’s forcing investors up the risk curve to chase higher yield (and lower quality) credits.

Rating transitions for the year were relatively benign with downgrades slightly outnumbering upgrades with the ratio near parity, reflecting continuing deterioration of the corporate and sovereign debt environments in Europe, interlaced with a more stringent approach being taken by all three global rating agencies when it comes to applying any leniency over the last six months in particular.

What is the Australian experience?

S&P provided its Australian data as part of its 2012 Annual Asia-Pacific Corporate Default Study rather than separately, however it is relatively easy to pick through. There were zero defaults of rated entities in Australia over the last year, the last default recorded by a rated company in Australian was Babcock and Brown International Pty Ltd.

There were a total of 1,811 company ratings included in the 2012 rating analysis for the Asia-Pacific region including 709 issuers rated in 2012.

Table 2

Table 2 demonstrates that the Asia-Pacific corporate rating market almost uniformly outperforms their global S&P peers. In the Asia-Pacific experience, the cumulative default rate for the lowest investment graded entities (BBB-category) over 10 years was 1.67%, favourably comparing to the 4.59% experienced in the global study.

What constitutes a default?

For the purpose of the S&P study, a default is recorded on the first occurrence of a payment default on any financial obligation rated or unrated (other than when subject to a bona fide commercial dispute). An exception is an interest payment that is missed on the due date but is made within the contracted grace period. Preferred stock is not considered a financial obligation; thus a missed preferred stock dividend is not normally equated with default. Distressed exchanges are considered a default; that is when bond holders are coerced into accepting substitute instruments with lower coupons, longer maturities, or any other diminished financial terms.

S&P deem ‘D’ (default); ‘SD’ (selective default); and ‘R’ (under regulatory supervision) as defaults for the purpose of the study.