The Standard and Poor’s global default statistics report reviews all rating activity undertaken by the agency across the globe, including monitoring defaults as well as rating movements (upgrades and downgrades). In 2012 there was a total of 84 defaults in the S&P global universe (of around 6,000 ratings), none of which were rated ‘investment grade’ (BBB- or better). There were no defaults recorded in Australia and only five in the Asia-Pacific region (two from China and one each from Indonesia, India and Japan).
On the rise
Defaults increased from 2011 (where 53 were recorded) reflecting the chase for high yield, particularly in the US, where investors have taken on more risk in order to achieve yields greater than on offer in the deposit market (see Figure 1 below). 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 that align with the GFC in 2009, the recession surrounding the ‘tech-wreck’ in 2001 and the recession a decade earlier in 1991.
[1]This 10-year cycle, which coincides with global or large-scale recessions, highlights our persistent theme here at FIIG for the need for portfolio asset diversification. Each of these default peaks corresponded to significant drops in equity prices. For investors looking to protect their capital, the S&P study shows investing in investment grade bonds to be a statistically safe way to diversify holdings and recession proof investment portfolios.
Investment grade stacks up
Whilst all of this makes for good reading for the 2012 year for investment grade market, the statistics over the 30-year study period also give confidence to investors in highly rated bonds. Last month [2], I questioned S&Ps changes to ratings on the corporate hybrids of Origin and Santos, this study shows when they stick to their core competency of rating companies, the rating agency gets it right, and most importantly adds value for investors.
[3]The cumulative default rates in the table above show the lowest investment grade ratings (BBB-category) cumulative default is only 4.59% over a 10-year period. Default rates step up considerably once you move down to sub-investment grade with a 10-year cumulative default rate of 15.09% for BB rated companies. The majority of defaults globally were recorded in the US, reflecting the nature of their bond market, which is the broadest and most mature of any of the global bond markets, and the decision by the Fed to maintain extremely low yields on treasuries, forcing investors up the risk curve to chase higher yield (and lower quality) credits.
The Australian experience
S&P provided its Australian data as part of its 2012 Annual Asia-Pacific Corporate Default Study rather than separately, however it is relatively easy to pick through. There were zero defaults of rated entities in Australia over the past year.
[4]Table 2 demonstrates the Asia-Pacific corporate rating market almost uniformly outperforms their global S&P peers. In the Asia-Pacific experience, the cumulative default rate for the lowest investment graded entities (BBB-category) over 10 years was 1.67%, favourably comparing to the 4.59% experienced in the global study.
The take away
Risk versus reward is a basic axiom of investing. Investors who blindly chase rewards without fully considering the risks involved rarely enjoy a soft landing. Risk versus reward could not be more graphically demonstrated than the default tables above – market corrections have happened before and will happen again. A diversified portfolio with a mixture of equities, bonds and cash will help ensure that investors achieve their objectives.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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