Corporate defaults and bankruptcies are on the rise, but we don't believe it should be a concern for investors who hold highly rated corporate bond investments, like those with investment-grade ratings.
Corporate defaults and bankruptcies are on the rise. That might seem troubling for corporate bond investors in general, but we don't believe it should be a concern for investors who hold highly rated corporate bond investments, like those with investment-grade ratings. Defaults tend to occur at the lowest rungs of the credit rating scales, not the highest rungs.
The rise in defaults doesn't mean investors need to abandon their corporate bond holdings, but it makes sense to take a look at what you own and try to limit your exposure to those bonds where default risk might be highest. Investment-grade corporate bonds still appear attractive, as their issuers generally have stronger balance sheets than issuers with sub-investment-grade ratings, and they generally have less refinancing risk as well. High-yield bond investments, however, could suffer price declines if defaults do continue to rise.
Defaults are on the rise
What does "default" mean? In its simplest form, it's when an issuer fails to make scheduled interest or principal payments on its bonds. According to credit rating agencies, if a corporation breaks one of its covenants, that can also trigger a default.1 For example, a covenant might limit how much debt an issuer can have relative to its earnings. The rating agencies also consider a "distressed-debt exchange" a default.2 Individual investors generally don't have much say in the details of a distressed-debt exchange, as the negotiations generally happen with large institutional investors who likely own a large portion of the debt. In a distressed-debt exchange, the value of the proceeds is generally below the initial par value of a given investment.
In fact, during most defaults, what's returned to bondholders (known as the "recovery rate") has historically been well below the bond's stated par value. According to Moody's, the average recovery rate for senior unsecured bonds was just 39 cents on the dollar, or 39% of a bond's par value.3
Corporate defaults are now occurring at the fastest rate since the fallout from the pandemic. According to Moody's Investors Service, the trailing 12-month speculative-grade default rate rose to 4.75% at the end of August 2023, its highest reading since May 2021, when defaults were on the decline. Default rates are generally calculated on a rolling 12-month basis, so as a high number of defaults roll out of the calculation, the rate naturally declines. The rate peaked at 9% in August 2020. The number of corporate defaults is expected to keep rising, according to both Moody's and Standard & Poor's (S&P).