Wednesday 04 November 2020 by Jonathan Sheridan Credit-ratings-800 Education (advanced)

Attempting to quantify the risk of bonds with credit ratings

In Australia credit ratings are only permitted to be disclosed to “wholesale” clients, which means that retail clients are not allowed to be shown credit ratings in relation to a particular product or for the purpose of procuring a sale. This article provides general credit rating information and is provided solely for educational purposes.

Credit ratings are an indication of perceived risk. Each year S&P Global Ratings releases a global report that shows defaults as well as rating movements (upgrades and downgrades).

The most recent Global Corporate Default Study and Rating Transitions report covers the 2019 year and reviews the rating agency’s actions taken worldwide including rating upgrades and downgrades. S&P also publishes a weekly summary of defaults so we can get the most up to date information (currently as at 19 October 2020). So far in 2020, there have been 189 defaults of companies rated by S&P globally. Comparing to the most recent high default years of 2016 (oil crisis) and 2009 (GFC), at this point in the year there have been 135 and 234 defaults respectively. An interesting point to note is that this year, distressed exchanges (where bondholders are offered a deal to exchange their bonds for new ones, usually at a price and new coupon lower than at issue of the original bond, which S&P counts as a default due to bondholders accepting terms less favourable than when the bonds were issued) are the second highest reason for default after missed payments.

This was also observed in 2009 and 2016, so it seems these types of exchanges become more prevalent in economic downturns as opposed to more ‘normal’ reasons for default, being the inability of the issuer to pay.

Indeed in 2019, distressed exchanges were the most prevalent reason for default, perhaps indicating that investors are increasingly accepting of this method of debt restructuring rather than a formal default or bankruptcy process. It should also be noted that the majority of cases in the S&P study are coming from the US, where the Chapter 11 process determines what happens to the company if declared bankrupt. This process is debtor-led rather than creditor-led (as is the case for voluntary administration in Australia) and the current pandemic has provided evidence that companies have been willing to file for Chapter 11 protection earlier than would have been seen in the past. As such, investors are more likely to accept a distressed exchange if there’s a heightened risk (perceived or real) of bankruptcy.

Global corporate defaults chart – investment grade versus speculative grade

credit-ratings-chart-1
The graph depicts the global corporate default percentages for investment grade, speculative grade and overall from 1981 – 2019
Source: FIIG Securities, S&P Global Ratings

This approximate 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.

In terms of where we are in this cycle, it is clear that defaults for 2020 are at or on the way to the highs experienced in previous recessions. However, given the vast amounts of monetary and fiscal stimulus thrown at the market in the first few months of this recession, the default cycle is likely still very early in its life, and we can expect numbers to continue to climb from here as stimulus, which to date has simply replaced lost economic output, tapers off and reality sets in.

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Investment grade stacks up over the life of the study

The statistics over the ~40 year study period should give confidence to investors in highly rated bonds. The table below 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 0.53%. This increases for the lowest investment grade credit rating to 2.64%.

In 2019, for the first time in 3 years, there were defaults from companies that began the year with investment grade ratings: Pacific Gas & Electric Co. and PG&E Corp, both rated BBB-. Effectively the same business, these issuers were the utility that was at the centre of the Californian wildfires tragedy and have subsequently been forced to take liability for the huge losses stemming from that event. In 2020 so far no investment grade issuers have defaulted.

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 and here for further information.

Global S&P cumulative default rates
credit-ratings-chart-2

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 2019 annual global corporate default study and rating transitions report
Source: FIIG Securities, S&P Global Ratings

The majority of defaults for 2019 were, as usual, recorded in the US, reflecting its large bond market which is the most mature of bond markets globally. As yields have remained low since the GFC, it reflects the macro trend of 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.

Unfortunately, there has been a high profile default in the domestic market this year which has affected many investors – that of Virgin Australia, rated B- immediately prior to default. There have been two other rated defaults from Australian issuers so far in 2020 – a distressed exchange from Boart Longyear, rated CC, and Speedcast International, rated CCC.

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. On-market purchases at a deep discount to face value are also generally considered a default.

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

Loss given default?

As mentioned above, it is important to distinguish between a default, which can be for many reasons (some of which are discussed above), and the loss that may eventuate as a result of that default, which is termed ‘loss given default”.

An example perhaps illustrates best:

Axsesstoday, an unrated issuer, defaulted in late 2018. It had issued a number of secured bonds in the OTC market as well as an unsecured listed retail bond on the ASX.

Investors in the secured bonds received 100% of their capital back but the unsecured bondholders are expected to receive less than 1/3 of their capital.

Therefore, from the same event of default, different investors had different loss outcomes depending on whether their bonds were secured or not.

This is an example of how capital structure is one of the many other determinants of risk in investing in bonds. We have focused in this article on ratings as there is an excellent data set which allows historical comparisons, but investors should be aware that ratings alone cannot quantify the risk of a bond investment, although they provide a good and relatively simple place to start.