The default rate measures the percentage of issuers in a given asset class that failed to make scheduled interest or principal payments in the prior 12 months. For example, if an asset class had 100 individual issuers and two of them defaulted in the prior 12 months, the default rate would be 2%. The default rate can also be “dollar-weighted,” meaning that it measures the dollar value of defaults as a percentage of the overall market.
Naturally, a high – or rising – default rate is a negative factor in the performance of an asset category, while a low – or falling – default rate helps support performance. Default rates tend to be highest during periods of economic stress, and highest during times in which the economy is strong. The default rate is a consideration for investors in municipal , investment-grade corporate, high-yield, and emerging market bonds, but it isn’t relevant for U.S. Treasuries since there is no chance that the federal government will default on its debt.
While a default is a catastrophic event for the price of an individual bond, in general defaults are relatively rate occurrences for all but the highest-rated securities. You can access historical data on corporate and high yield default rates from the rating agency Standard & Poor’s by clicking here. This site, which contains a treasure trove of data dating back to 1981, provides some insight into the likelihood of default for investment grade and high yield bonds. It’s worth taking a moment to scan the charts and tables to learn more about defaults, but some notable takeaways are:
- Default rates have been quite low in the corporate bond market over time, averaging 1.47% of all outstanding issues in the 31-year period measured. Investment grade bonds defaulted at a rate of just 0.11% per year, while the default rate for below-investment grade (high yield) bonds was 4.26%.
- The vast majority of defaults have occurred among the lowest-rated issuers. The 31-year average for securities rated AAA (the highest rating) and AA were 0.0% and 0.2%, respectively. Comparatively, the default rate among B-rated issuers (the second lowest) was 4.48%, but for the lowest tier, CCC/C, the default rate was 26.82%.
- By a wide margin, the majority of defaults are preceded by downgrades to the issuer’s credit rating. As a result, most defaults are likely to be preceded by a warning.
Municipal bonds also have exhibited a low default rate. In the 39 years ended in 2010, the default rate for all municipal issues (both high- and low-rated) was 2.7%. However, according to the rating agency Moody’s, the default rate rose to 5.5% in 2010 and 2011 amid the ongoing reverberations from the housing market collapse. Still, as was the case in the corporate sector, most of the defaults occurred among the lowest-rated securities in the sector. According to the website fmsbonds.com, “Of the bonds that did default, the major cause, according to Moody’s, was ‘enterprise risk.’ This risk results from a failure of a bond-financed project to achieve its projected results due to faulty planning or economic downturn, rendering a project unfeasible.”
From these factoids about the corporate and municipal bond markets, it’s evident that investors can largely limit their exposure to default by investing in funds that concentrate on higher-rated securities. Still, even an investor who holds bonds or bond funds that completely avoid defaults are still subject to Learn more interest rate risk – and therefore not immune to loss of principal.