With the CPI printing today at a 40-year high, the Fed will have to follow through next week on their threat to raise interest-rates, which means more stress on an already weakened economy, which means more bond defaults. (Yeah, I’m simplifying. But I prefer to think defensively, on the theory that "Better a missed opportunity than a realized loss.) Historically, this is reported to be the rates at which bonds default.
**Moody’s S&P** **Rating Muni Corp Muni Corp** **Aaa/AAA 0 0.52 0 0.6** **Aa/AA 0.06 0.52 0 1.5** **A/A 0.03 1.29 0.23 2.91** **Baa/BBB 0.13 4.64 0.32 10.29** **Ba/BB 2.65 19.12 1.74 29.93** **B/B 11.86 43.34 8.48 53.72** **Caa-C/CCC-C 16.58 69.18 44.81 69.19**
What’s surprising is how well spec-grade munis hold up. But take a look at the default rates for corporates --which I’d extrapolate to preferreds as well-- and average what SP & Moody’s report and then round up to the nearest whole number.
**Aaa/AAA, 1%** **Aa/AA, 1%** **A/A, 2%** **Baa/BBB, 8%** **Ba/BB, 25%** **B/B, 49%** **Caa-C/CCC-C, 69%**
Some obvious points.
(1) Both agencies report little difference in defaults whether the bond is rated ‘top tier’ or one trache lower, and for my own purposes --when buying bonds or running analytics on my portfolio-- I lump the two tranches together and call them ‘Defensive’ (in Ben Graham’s sense of that term.)
(2) Frankly, I think the low default-rate reported for single-A’s is misleading. What more likely to be happening is that a significant number of single-A’s get downgraded to triple-BBBs (or lower) and then they crashed. Hence, I don’t consider single-As to be a “Buy 'em and Forget 'em” tranche. More likely, they are what Ben Graham would consider to be “Enterprising”.
(3) Both agencies report little difference in defaults for anything they rate as ‘bottom tier’. Clearly, that tranche isn’t merely ‘speculative’. It’s TRASH, and it should be avoided by the “average” investor, with this exception. Just as buying far out of the money options can pay off hugely if bought cheaply enough, in a large enough sample to capture the statistical advantage offered by that game, buying bottom tier stocks/bonds/whatever can pay off if the price is low enough and the payouts are high to cover the losses that have to be suffered. (This is a post for another time.)
(4) Most investors feel comfortable buying triple-BBB debt, because they are lulled into a false sense of security by the fact that tranche is still considered ‘investment-grade’. I think this is a risky, unwarranted assumption, for two reasons. An 8% default rate means you’re likely to lose one out of twelve positions. Not just suffer an adverse price movement, but lose the whole thing. This isn’t to say that the risks of that tranche can’t be managed. But, clearly, anything that falls into that tranche isn’t a ‘Defensive’ investment. At best, it is ‘Enterprising’ (in Ben Graham’s sense of that term) --if not border line “Speculative” – and requires active monitoring and management. Second, and more importantly, if an issuer’s debt is downgraded from ‘investment grade’ to ‘spec-grade’, many institutionals will be forced to sell those bonds. Hence, both the issuers and the large owners have every reason to avoid that event, and they will fudge their financials and bribe the agencies to prevent such a downgrade from happening. (Can’t happen? Won’t happen? Watch The Big Short again.) Your takeaway should be this. The fact that Moody’s/S&P/Fitches rates a bond or preferred as such as such is merely their opinion, which might not be timely and might not be unbiased, no matter how well informed and informative nearly every rating is. (Read a couple hundred of them, and you’ll quickly appreciate the tool and help they can be.)
So here’s a follow-up on that supposed 8% default rate (which is probably actually closer to 13%). If you buy a dozen triple-BBB bonds from properly diversified issuers, how many should you expect to blow up on you? Roughly, one in twelve, right? But, No. What you actually own is only a small sample of the data set from which the default-rate was derived, and your personally-experienced default-rate might be quite different. In fact, there is no reason that every one of your twelve bonds --or pfds-- couldn’t default. Not likely. But not impossible, as it is easy to see with a coin-flipping example.
If you have a $1 and I have $10, we could flip for pennies all day, and neither of us would walk away a significant winner. But if I talk you into flipping for quarters, there’s a very real possibility (1/16) that I’ll bust you in four flips. It’s been too many years since I’ve had a stats/probability class. But the math roughly goes like this. In the “good, old days”, BKs weren’t a thing to fear. By and large, there was some sort of workout offered to creditors that minimized the damage of suffering a default. (In fact, a couple of times, I was able to come out money ahead.) But those days are past. Now, when an issuer defaults, you likely to receive nothing. If you got into the bond at 60 or 70, your losses won’t be as great as getting in near par or at a premium to par, which is why entry price matters and why position size matters and why sample size matters. If you’re carrying hundreds of positions, and if those positions aren’t the whole of your portfolio, then your due diligence can be pretty sloppy and you’ll likely survive. But if the whole of your portfolio is just a limited number of positions, and if you’ve chosen them on the basis of agency ratings --without confirming those ratings with your own due diligence–, you shouldn’t be surprised if some of them blow up on you, especially in our current market and economy.
(to be con’t)