Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
For many investors, fixed income investments have a primary objective of preserving wealth. The known characteristics of owning individual bonds are a major reason for this: known income, known cash flow, known redemption date, known redemption value. From day one when you purchase a bond, all of this is locked in and does not change. This is because when you purchase a bond, you are essentially lending money to the issuer, who is legally bound by a set of fixed terms that were laid out when they issued the bond. There are primarily two ways that these known outcomes won’t come to fruition. One is if you choose to sell the bond prior to it being redeemed, which is something that is controlled by you, the investor. The other is if the issuer defaults. While the risk of a default can never be completely eliminated, choosing high credit quality issuers can help to minimize the chances of a default as using investment-grade credits makes a default event highly unlikely.
While the past is not a guarantee of what future results will be, analyzing historical data can provide valuable insights and help to ensure that investment choice aligns with personal risk considerations. The chart below shows the average default rate over a rolling 5-year period for corporate bonds from 1983 to 2022. The ratings listed above the red line are investment-grade. The ratings listed below the red line are speculative-grade, also known as high-yield or junk bonds. The Default Rate column are the Moody’s reported statistics. In my opinion, looking at things from the opposite point of view helps to put things in perspective, so the “Non-Default Rate” column was added. This shows the percentage of time that a bond in each category did not default over a 5-year period. For example, if you owned an A-rated corporate bond, there is a 99.3% chance that the bond didn’t default over a given 5-year period.
These numbers help to explain why many investors choose to allocate the fixed income portion of their portfolio into investment-grade corporate bonds. For an investment intended to preserve wealth, a ~99% “success rate” of an investment doing exactly what it said it was going to do is an attractive opportunity. Even at the low end of the investment-grade spectrum (Baa rated bonds), a 98.55% non-default rate combined with the yields available represents an attractive risk/reward dynamic for investors. Another thing to keep in mind when looking at these numbers is that, although anything is possible, the move towards a default generally takes places over a period of time and can be witnessed as a string of downgrades as the credit quality of the company gradually deteriorates. Oftentimes, this gives investors the opportunity to sell the bond well before a company defaults if the credit quality of the issuer no longer aligns with an investor’s risk tolerance.
On the other side of the coin, looking at the speculative-grade statistics, the increased risk in buying junk bonds is clear. Just crossing over the threshold by one rating category, from Baa to Ba, sees a fivefold increase in the average default rate. Jump down one more category and the numbers increase to 1 in 5. That is not to say that these bonds do not have a place in some portfolios, but for the capital preservation portion of a portfolio, investment-grade bonds are much better suited to the task.
