Don’t Be Scared to Purchase Individual Junk Bonds

September 28th, 2012 by

By: The Financial Lexicon

When venturing into the world of junk bonds, it may feel safer to purchase a diversified high-yield mutual fund or ETF as opposed to buying individual bonds.  I agree that diversification is an important element of any portfolio, especially among non-investment-grade bonds.  But I would also like to note that the risks of default among issuers of high-yield debt may not be as great as many investors assume.  For details on historical default rates among junk bonds, let’s turn to Moody’s Investors Service’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2011.

From 1920 to 2011, the average annual default rate for non-investment-grade corporate bonds was 2.802%. That compares to a 13.076% default rate during the financial crisis in 2009 and the highest single-year default rate of 15.641% in 1933.  During the worst of the Great Depression and during what was perhaps the worst financial crisis in U.S. history, defaults on high-yield bonds reached levels in the 13% to 16% region.  The relatively low average annual default rate, combined with what appears to be an upper bound for default rates in the 13% to 16% region, seems to imply that investing in the high-yield market is not as scary as it is sometimes made out to be.  This is especially true if you have the wherewithal to ride out and even add to positions during periods of turmoil in the financial markets.

With that said, nobody wants to be caught owning the bonds that do default.  Therefore, when creating a diversified individual bond portfolio in the high-yield space, the following default rates, broken down by credit rating, may be of interest.

Again looking at the 1920 to 2011 time period, among corporate bonds with Ba1 to Ba3 ratings, the average annual default rate was just 1.073%.  This was actually slightly lower than the average annual default rate of 1.156% for the entire corporate bond universe. Among single B rated bonds (B1 to B3), the average default rate was 3.423% during the same time period.  But here is where things take a turn for the worse.  For corporate bonds rated Caa1 and below, the average annual default rate jumps to 13.769%.  In 2009, the default rate was 34.028%, and there have even been several instances of the annual default rate for bonds rated Caa1 and lower exceeding 40%.

Furthermore, keep in mind that if you are unfortunate enough to purchase debt of an issuer that defaults, there is typically a recovery rate on the bond.  From 1987 to 2011, the average corporate debt recovery rate for senior secured bonds was 63.7 cents on the dollar. Among senior unsecured bonds, it was 48.5 cents on the dollar, and for subordinated bonds, the recovery rate was 28.7 cents on the dollar.

Given the relatively low average annual default rates among Ba and B rated corporate bonds, combined with average recovery rates of just under 50 cents on the dollar for senior unsecured bonds, the risk-reward seems acceptable for owning individual bonds in these ratings categories.  Of course, a bond’s rating could migrate to the lowest regions of the junk bond world while you own it. Therefore, let’s take a brief look at the “Average Five-Year Letter Rating Migration Rates, 1970-2011,” from the same Moody’s study.  During the 1970 to 2011 time frame, an average of 7.835% of bonds with Ba1 to Ba3 ratings eventually defaulted over the subsequent five years.  Among B1 to B3 rated bonds, 19.201% of bonds defaulted over the subsequent five years.

Regarding bonds rated Caa1 and below, I would look to ETFs or mutual funds in order to gain exposure to that part of the junk bond market.  After all, when investing in a part of the ratings spectrum in which it is not uncommon for the annual default rate to exceed 20%, it seems prudent to shy away from purchasing individual bonds.  In the rest of the high-yield bond market, however, purchasing individual bonds is something to seriously consider.

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