Tuesday 28 February 2017 by FIIG Research Education (advanced)

Quantifying the risk of bonds with S&P credit ratings

Credit ratings are an indication of perceived risk. Each year Standard and Poor’s release a global report that shows defaults as well as rating movements (upgrades and downgrades)

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The most recent Global Corporate Default Study and Rating Transitions report covers the 2015 year and reviews the agencies actions taken worldwide including rating upgrades and downgrades.

In 2015, 113 global corporate issuers defaulted – nearly double the 60 defaults in 2014.The increase in defaults accordingly pushed the speculative grade default rate up from 1.43% in 2014 to 2.75% in 2015. Of these 113 corporates that defaulted, none were Australian companies.

We note that markets continue to recover post the global financial crisis when defaults hit a historical peak of 268 in 2009 (see Figure 1). 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.

Global corporate defaults chart – investment grade versus speculative grade

Figure 1
The graph depicts the global corporate default perchanges for investment grade, speculative grade and overall from 1981 – 2015
Source: FIIG Securities, Standard and Poor’s

This 10 year cycle, which coincides with global or large scale recessions, highlights the need for portfolio asset diversification. Each of these default peaks corresponded to significant drops in equity prices. While the peak was 268 rated defaults in 2009, global investment grade defaults peaked at 14 in 2008 – from a sample of over 3,000. 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

The statistics over the 30 year study period should give confidence to investors in highly rated bonds. The table shows the probability of default given the term to maturity. For example, an A- rated bond has a probability of default over five years of 0.68%. This increases for the lowest investment grade credit rating to 3.44%.

It’s important to note that a default means the company failed to meet its interest or principal obligations by the due date and does not mean the investor lost money – see a definition at the end of the note.

Global S&P cumulative default rates

Table 1
The table shows the probability of default for AAA rated to BBB- including average default rates of investment grade, speculative grade and all rated. Data from S&P’s 2015 annual global corporate default study and rating transitions report
Source: FIIG Securities, Standard and Poor’s

The majority of defaults for 2015 were recorded in the US, reflecting its large bond market which is the most mature of bond markets globally. It also highlights the Fed’s decision to maintain extremely low yields on government Treasury bonds, forcing investors up the risk curve to chase higher yield (and lower quality) credits.

An Australian default?

Historically, the Australian default statistics are lower than the global statistics, in part due to our almost exclusively investment grade market, but also due to our concentration towards stronger, larger financial institutions.

In 2013 however, Australia did record its first default – since the beginning of the GFC – with CCC+ rated Mirabela Nickel Ltd missing an interest payment on its USD loans.

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 that is rated or unrated – other than when subject to a bona fide commercial dispute. An exception is when an interest payment is missed on the due date, but is made within the contracted grace period. Preferred stock is not considered a financial obligation; 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.


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