Earlier this month Standard & Poor’s released their default statistics data which highlight the very low risk nature of the bond market.

Credit ratings play a very important role in bond markets. A high credit rating (in the ‘A’ range) means the issuer will have a lower cost of funding, so companies often try and manage their financial profile and ratios to meet credit rating agency minimum standard hurdles.

Global credit rating statistics

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).

Most senior debt in Australia is issued for a five year term, so let’s have a look at Table 1 below showing historic defaults over a five year term. (Note: these statistics relate to a 31 year data collection period from 1981 until 2012). Those issues in the ‘A’ range had a less than 1% default rate and only 0.62% of single ‘A’ credits defaulted in that period globally. The figure jumps in the ‘BBB’ range to 2.18%, but this remains a low risk of default. While the company may default it doesn’t automatically mean bond investors lose money. There are many possible outcomes in a workout scenario, but I’ll focus on the stats for this article. If you continue to run your eye down that five year column, you’ll see a significant increase when the rating drops to the non-investment grade ‘BB’ range and defaults jump to 8.37%.

Table 1

Note: 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).

There’s just two other figures I want to draw to your attention. At the end of the five year column is an average ‘investment grade’ default of 1.12% and a ‘speculative or non-investment grade’ average default of 16.44%. Investors can take comfort in the low 1.12% risk of default for global investment grade issues.

Asia-Pacific statistics

Local statistics are even better than the global results (see Table 2). 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 was 1,811 company ratings included in the 2012 rating analysis for the Asia-Pacific region including 709 issuers.

If we focus on the five year column again, you can see that there are virtually no defaults in the ‘A’ range and just 1.15% in the BBB range giving an average default statistic for investment grade issues of 0.50%, which I consider very low risk. Even if you look at the ten year default rate for a BBB range credit, it remains very low risk at 1.67% - and this is for the whole Asia-Pacific region. Again, consistent with the global experience, we see a significant increase in defaults once issues fall below the investment grade level.

Table 2

Health of the global economy

The number of global defaults is an indication of the health of global markets. For example at the height of the GFC, the number of global defaults hit an all-time high of 265 (see Figure 1 below). The 2001 peak in the graph reflected the ‘tech-wreck’ and the peak in 1990 a recession. In 2012 the global risk of default was on the rise again, up to 84 defaults from 53 defaults recorded in 2011.

Figure 1

Each of the default peaks shown in the graph corresponded to significant drops in equity prices. The 2009 peak with 265 rated defaults only consisted of 14 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.

Don’t confuse the credit ratings

Did you know that credit ratings are purely for debt and the equity (shares) of a company are never rated?

Interestingly when company credit ratings or “issuer” ratings are published, they are usually for senior unsecured debt. Rating agencies also rate individual bond issues and these ratings can be higher or lower than the issuer rating. The Commonwealth Bank is a good example (see Table 3). The CBA’s issuer rating is AA- but its covered bonds are considered very low risk and S&P have rated them three notches higher at ‘AAA’. Moving down the capital structure, risk is increasing and the credit ratings are appropriately decreasing with CBA hybrids generally rated ‘BBB+’, six notches lower than the covered bonds and four notches lower than the ‘published’ company rating. Big UK bank, Barclays has a greater seven notch disparity across its capital structure.

Investors need to check exactly what the rating is for and not assume the issuer rating applies across the capital structure.

Table 3

In conclusion, S&P’s credit rating default tables provide comfort of the very low risk of the bond market.