Tuesday 04 July 2017 by FIIG Securities motocross 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)

The most recent Global Corporate Default Study and Rating Transitions report covers the 2016 year and reviews the agency’s actions taken worldwide including rating upgrades and downgrades.

In 2016, 162 global corporate issuers defaulted, from 113 defaults in 2015. The increase in defaults pushed the speculative grade default rate up from 2.8% in 2015 to 4.2% in 2016 – its highest level since the GFC when it was just under 10%. Of the 162 corporates that defaulted, two were Australian companies – Atlas Iron Ltd, and Barminco Holdings. Neither of these companies were rated investment grade prior to default.

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 percentages for investment grade, speculative grade and overall from 1981 – 2016
Source: FIIG Securities, S&P Global 

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.

There were no investment grade defaults in Australia or globally during 2016.

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 just 0.60%. This increases for the lowest investment grade credit rating, over the same term to 3.01%.

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 2016 annual global corporate default study and rating transitions report
Source: FIIG Securities, S&P Global

The majority of defaults for 2016 were recorded in the US, reflecting its large bond market which is the most mature global market. Cumulatively, 162 companies defaulted on approximately USD239.8bn of debt over 2016. It also highlights the Fed’s decision to maintain low yields on government Treasury bonds, forcing investors up the risk curve to chase higher yield (and lower quality) credits.

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.

A closer look at Australia's two 2016 defaults

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.

In 2016 two Australian companies went into selective default – Atlas Iron (Atlas), an independent iron ore company and Barminco Holdings (Barminco), whose core business is mechanised underground mining services. Both companies were subsequently rerated and continue to operate.

Neither Atlas or Barminco were rated investment grade prior to defaulting. In fact, S&P stated that all 2016 defaulters which had active ratings immediately prior to default were rated in the lowest rating categories (BB+ to C; non investment or “speculative” grade). We note that S&P’s long term investment grade ratings range from AAA (highest) to BBB-.

Atlas Iron LtdExternal link - opens in a new window

On 9 May 2016, S&P lowered its long term corporate credit rating on Atlas to SD from CC. The rating action was a result of Atlas issuing $6bn of fully paid ordinary shares, and more than $4bn of options to its term loan B (TLB) lenders, in exchange for a reduction in its principal loan payment under a creditors’ scheme of arrangement. S&P subsequently viewed this as a distressed exchange as the creditors received less than what was promised on the original TLB.

On 19 May 2016, S&P after completing their review of Atlas’ operations and new capital structure, raised its long term default credit rating to CCC from SD.

Atlas’ selective default lasted 10 days. S&P stated:

“We have completed our review of Australian iron ore producer Atlas Iron's operations and new capital structure following its implementation of a debt restructure that we viewed as equivalent to a distressed exchange. We are raising our corporate credit ratings on the company to 'CCC' from 'SD' […] The outlook is developing, reflecting Atlas Iron's extreme sensitivity to movement in iron ore prices and the Australian dollar to U.S. dollar exchange rate. In our view, a small change in these assumptions could push the company to either breach its covenant, or accumulate cash and materially reduce its net debt.”

Credit rating history

Source: S&P Global

Barminco Holdings Pty Ltd
External link - opens in a new window

On 15 June 2016, S&P lowered its long term corporate credit rating on underground hard rock contract miner Barminco to SD from B-. The rating action followed Barminco’s repurchase of its 2018 bonds at below par value. Per S&P’s rating criteria, this is viewed as similar to a de-facto restructuring and selective default.

The following day, S&P raised its corporate credit rating to B- from SD, based on its review of Barminco’s operations and capital structure following its note repurchase.

Finally, on 18 October 2016, S&P revised Barminco’s outlook to positive from stable. This reflected S&P’s view that Barminco’s credit metrics would continue to improve through a material reduction in its adjusted debt, as well as its good track record of managing its contract book with growth in earnings.

Barminco’s selective default lasted just one day. S&P stated:

We have reviewed the ratings of Australian hard-rock contract miner Barminco Holdings Pty Ltd. following the completion of the company's recent note repurchases at below par value, which we viewed as a de-facto restructuring. Barminco's experience and track record in providing underground hard-rock mining services partly offset the challenging industry conditions and the company's relatively small scale and narrow business focus. As a result, we are raising our corporate credit rating on the company back to 'B-' from 'SD' […] The outlook is stable, reflecting our expectation that the company will continue to successfully manage its contract book, maintain its steady track record in providing underground hard-rock mining services, and will proactively manage upcoming refinancing risks.”

Below is a graph showing price movements of the Barminco 2018 bonds over the last three years, and its credit rating history. 

Source: Bloomberg, FIIG Securities

Credit rating history

Source: S&P Global