Through September 12, 2012, year-to-date investments into U.S. taxable bond funds totaled over $324 billion according to the Investment Company Institute. At the same time, over $237 billion flowed out of U.S. stock mutual funds.
Essentially, many investors decided that the prospect of continuing to invest in bonds at historically low interest rates is more appealing than the risk of owning more U.S. stocks should another recession or bear market occur.
Many investors, aware of the negative real return presented by owning U.S. Treasury bonds with payments lower than inflation, have chosen to invest in corporate bonds instead, expecting higher income payments. According to a note in the Sept. 25 Wall Street Journal, even corporate bond payments are near record lows. The rate of high-yield, or “junk” bonds, above comparable maturity Treasuries was 5.42 percentage points, down from 9.1 percentage points just a year ago.
The search for higher yields makes it very important to understand the risk inherent in corporate bonds.
According to research from Asset Dedication, LLC, from 1970-2009 the default rate on U.S. corporate bonds by rating class over the first 10 years after issuance was:
|Bond Rating||Default Rate||Moody’s Comment|
|Aaa||.5%||Highest quality, minimal credit risk|
|Aa||.54%||High quality, very low credit risk|
|A||2.05%||Upper-medium grade, low credit risk|
|Baa||4.85%||Medium grade, moderate credit risk|
|Ba||19.96%||Have speculative elements and substantial credit risk|
|B||44.38%||Speculative and high credit risk|
|Caa – C||71.38%||Poor standing or in default and very high credit risk|
This table shows the non-linear nature of the risks of owning corporate bonds of different qualities. High-quality bonds (Aaa and Aa) have similar default rates that have been historically very low. As you get lower on the quality ladder, however, the risks of owning these bonds tends to go up very quickly, so when you get to high-yield bonds (generally B and below) the default rates are above 50% on average.
These default rates go up and down based on the performance of the overall U.S. economy. If earnings are pretty good, and the U.S. economy is doing OK, the default rates of lower-quality bonds are usually lower than the table above. When the economy hits a rough patch the performance of these companies suffers, and more of them are unable to cover the interest payments that they owe. They default and provide no or reduced payments to shareholders.
We suggest that before you buy a bond mutual fund you learn more about the rating of the bonds held within the fund. With this information you can get an idea of how much risk you are taking with this portion of your investment portfolio.
BEWARE OF AVERAGE CREDIT QUALITY
Be careful not to place too much weight in your evaluation on the average credit rating of a bond mutual fund or exchange-traded fund. As referenced above, the advancement of default risk is not linear. However, when determining average credit quality, most fund firms and research organizations treat the calculation as if there were a linear progression of risk.
According to a note in the September 12 edition of ETF Report, “most data services assign each rating a grade: AAA=1, AA+=2, AA=3, and so on. The numeric values are summed up and averaged. With one bond in each tier, the average credit rating is BB+, one notch below investment grade.” This presents a problem because while the difference between AAA and AA may not be significant, the difference between CCC and C+ is massive. If you use actual default rates rather than just assigning a value to each tier, the expected default rate of the overall portfolio would climb from 0.63% for the simple math approach to 2.73% for the actual experience approach. That’s 333% increase in default rate.
How do you feel about investing in bonds in today’s market environment?
Have low interest rates forced you to change your investment approach?
~ Allyn Hughes, CFP®, CLU®, ChFC®, Brooks, Hughes & Jones – Partners in Wealth Management, Tacoma, WA — www.BHJadvisors.com