A long-term look at default risk in bond markets

The fallout from the recent financial crisis still has many investors worried about bond defaults, as bonds are typically a safe haven for many investors. It's certainly understandable. Seeing your investing safe haven disrupted can be tough to stomach from a long-term investing perspective.

But a new paper should help calm some fears about such defaults. The authors of the study, "Corporate Bond Default Risk: A 150-Year Perspective," analyzed corporate bond default rates for the period 1866-2008. The following is a summary of their findings.

While the long-run average default rate is 1.5 percent, the distribution of defaults isn't normal. Instead, we see long periods of very few defaults coupled with short bursts of heavy defaults. For example, during the railroad crisis of 1873-1875, total defaults amounted to 36 percent of the par value of the entire corporate bond market, almost three times the rate experienced during the Great Depression (which barely made the top five default rates).

The credit spread, or the differential between corporate bonds and riskless Treasurys, has averaged 1.53 percent. However, the realized premium, at about 0.8 percent, has been only about half as much, providing only a modest premium for accepting the risks of corporate debt.

In addition, credit spreads don't adjust in response to realized default rates and have no predictive power of default rates. They're largely driven by factors such as illiquidity.

Surprisingly, default events are only weakly correlated with business downturns. Recession indicators have little predictive ability for corporate default rates -- the correlation between credit events and National Bureau of Economic Research (NBER) business downturns is only about 26 percent. One reason for the low correlation is that while default cycles are less frequent than recessions, they're more persistent. While the average duration of a recession is about 1.5 years, the average duration of a default cycle is more than twice as long at about 3.2 years.

The variables of credit risk (such as firm value, leverage, interest rates, the slope of the term structure and volatility) have significant forecasting power for corporate defaults. Credit spreads and stock market return are negatively correlated, with spreads tightening as the stock market increases in value.

The findings of the study demonstrate why one of my favorite sayings is that there's nothing new in investing, only the investment history you don't know. Whenever interest rates are at historically low levels, investors tend to stretch for yield. This leads to the mistake of confusing the yield on a bond with its return. In the presence of credit risk, the yield isn't even an estimate of the expected return. The yield not only includes a premium for expected credit losses, but because investors aren't risk neutral (but are risk averse), it should also include a further premium for taking the risk that losses will be greater than expected. The yield also includes a premium for illiquidity relative to U.S. Treasury securities. And, if the bond has a call feature, it will also include a premium for accepting reinvestment risk.

Given the risks, the realized return can be quite different from the yield at which the bond was purchased. Yet investors continue repeating this behavior. As Spanish philosopher George Santayana warned: "Those who cannot remember the past are condemned to repeat it."