How likely is it for a corporate bond rated BAA3/BBB to fail?

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JimmyJammy
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How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by JimmyJammy » Wed Sep 19, 2018 1:10 pm

I was looking at a new issue corporate bond. From Ford - a Credit Note. It matures in 2023 - not too far away. And its expected yield is 4.5% I like the yield...

But the Moody rating is BAA3/BBB and the Moody outlook is negative.

So, how risky would this be to participate? What percentage of these notes, with this kind of rating, fail?

And if it failed, would I lose all my money in the bond?

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vineviz
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by vineviz » Wed Sep 19, 2018 1:25 pm

JimmyJammy wrote:
Wed Sep 19, 2018 1:10 pm
So, how risky would this be to participate? What percentage of these notes, with this kind of rating, fail?
Historically, about 5% of such bonds default. Keep in mind that during a financial crisis (e.g. 1987, 2000, 2007) the default rate can spike to 10% or higher.

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JimmyJammy wrote:
Wed Sep 19, 2018 1:10 pm
And if it failed, would I lose all my money in the bond?
Probably not. You'd collect full coupon payments up until the time of default, then you'd get some percentage of your principal back in a restructuring or bankruptcy proceeding. Recovery rates for credit notes are typically 25-30% IIRC.

I'd avoid it. If the position is big enough that the extra yield makes any difference, it's too much risk. If the position is small enough to contain the risk, the upside is minimal. If you are feeling lucky and want to gamble a diversified portfolio (e.g. iShares Fallen Angels USD Bond ETF [FALN]) is probably smarter than a single junk bond.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Thesaints
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by Thesaints » Wed Sep 19, 2018 1:27 pm

With some googling effort you may be able to find an interesting table I saw a few years back, reporting the default percentage of bonds as a function of their rating and the number of years after that rating.
If I remember correctly for a BBB we are talking of a single digit number, integrating down the road.

JimmyJammy
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by JimmyJammy » Wed Sep 19, 2018 2:26 pm

Ok, thanks all. This helps clarify the risk involved.

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Taylor Larimore
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by Taylor Larimore » Wed Sep 19, 2018 2:28 pm

JimmyJammy wrote:
Wed Sep 19, 2018 1:10 pm
I was looking at a new issue corporate bond. From Ford - a Credit Note. It matures in 2023 - not too far away. And its expected yield is 4.5% I like the yield...

But the Moody rating is BAA3/BBB and the Moody outlook is negative.

So, how risky would this be to participate? What percentage of these notes, with this kind of rating, fail?

And if it failed, would I lose all my money in the bond?
JimmyJammy:

No one knows what the Ford bond fund will do. This is one reason I much prefer a good quality, low-cost mutual fund with its greater diversification (less risk).

If you are dependent on your Ford bond for retirement, you are making a mistake. Remember when GM went bankrupt.

"More money has been lost by investors seeking higher yield than has been lost at the point of a gun."


Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

jminv
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by jminv » Wed Sep 19, 2018 4:02 pm

Since there is default risk, you might want to look at a diversified portfolio of bonds rather than one bond from a singular issuer.

TN_Boy
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by TN_Boy » Wed Sep 19, 2018 4:17 pm

JimmyJammy wrote:
Wed Sep 19, 2018 2:26 pm
Ok, thanks all. This helps clarify the risk involved.
Doesn't clarify the risk at all. Over a large number of BBB rated bonds you know what the historical default risk has been.

But you most assuredly do not know what the default risk is for a single company -- Ford --- over the next five years or so.

I don't think Ford will go under in that timeframe, but there is a reason they had to offer a high interest rate to sell that bond. Suppose oil prices go back up a lot. Ford is dependent upon the sales of pickup trucks and SUVs to survive. I could see them taking a huge beating quickly.

To me, the fact that they have thrown in the towel on making sedans is a sign they are unable to compete effectively, but that's just my take.

Thesaints
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by Thesaints » Wed Sep 19, 2018 4:22 pm

Well, if all BBB bonds have about the same risk (which is kind of what the concept of rating implies), then the table tells you that Ford bond has between 5 and 10% chance of default. That's all the table says.

It is very true that our personal risk assessment has to analyze both cases, the one with a 90/95% chance of occurring where the OP makes 4.65% per year and the one with 5/10% chance of occurring, where he loses 70% of his capital.
And it should be abundantly clear that it will be either one or the other, no half-way, middle of the road solutions.

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randomizer
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by randomizer » Wed Sep 19, 2018 4:39 pm

Chase yield on the equity side, not the bond side. If you get into corporate bonds in search of yield, you're unnecessarily increasing your risk because corporate bond correlation with equity with approach once when things hit the fan.
87.5:12.5, EM tilt — HODL the course!

venkman
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by venkman » Wed Sep 19, 2018 9:47 pm

The credit spread between corporate bonds and Treasuries bottomed out in early February of this year. It's rebounded somewhat, but it's still pretty low. I think corporate bonds can be worth the risk, as long as you're being rewarded appropriately for taking that risk. Right now, the reward just isn't there.

https://fred.stlouisfed.org/series/BAMLC0A4CBBB

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villars
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by villars » Wed Sep 19, 2018 10:14 pm

venkman wrote:
Wed Sep 19, 2018 9:47 pm
Right now, the reward just isn't there.

https://fred.stlouisfed.org/series/BAMLC0A4CBBB
I read that all the time on this board. Corporate bonds are not worth the risk, and "take risk on the equity side"

If that is true, wouldn't the lack of demand cause the price of corporate bonds to drop ( ie yield goes up) until they become worth it? In other words how is the average boglehead different from the market at large when it comes to high yield and Corporate bonds?

venkman
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by venkman » Wed Sep 19, 2018 10:51 pm

villars wrote:
Wed Sep 19, 2018 10:14 pm
I read that all the time on this board. Corporate bonds are not worth the risk, and "take risk on the equity side"

If that is true, wouldn't the lack of demand cause the price of corporate bonds to drop ( ie yield goes up) until they become worth it? In other words how is the average boglehead different from the market at large when it comes to high yield and Corporate bonds?
The default BH bond fund is Total Bond Market (VBTLX), which has a not-insignificant percentage of corporate bonds. I believe Jack Bogle himself has opined that it doesn't have enough exposure to corporates.

I don't think the main BH issue with corporate bonds is the added risk; it's that corporate bonds tend to correlate more with stocks. For most people, the purpose of bonds is to add stability to their portfolio. The risk of corporate bonds is greatest during an economic downturn, so prices for those bonds will tend to decline at the same time stocks are declining.

fennewaldaj
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by fennewaldaj » Wed Sep 19, 2018 11:19 pm

Its worth noting that if you hold an investment grade bond fund your BBB bonds aren't likely to fail they are likely to get downgraded and sold. Its my understanding that even Vanguards high yield fund rarely keeps bonds until they actually default.

BespokeBiker
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by BespokeBiker » Wed Sep 19, 2018 11:47 pm

I just looked into this recently because several Vanguard bond index funds include roughly 20-25% BBB rated bonds. The best answer I got is from an NYU - Stern study: http://people.stern.nyu.edu/ealtman/Abo ... tRates.pdf. See Table 15.5, which compares numbers from Moody's, S&P and Altman.

***EDIT: Above Link CORRECTED (retrieves PDF of Altman paper)***

Short answer: All 3 agree that 10-yr cumulative default risk takes a significant rise going down to BBB/Baa from A/A. [Moody's/S&P rating nomenclature] However, it appears that out of a pure BBB bond index it's "only" 4-8%, as opposed to 20-65+% as you drop further into Junk..excuse me...High Yield.
Last edited by BespokeBiker on Thu Sep 20, 2018 3:42 pm, edited 2 times in total.

Jacobkg
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by Jacobkg » Thu Sep 20, 2018 1:53 am

Risks that can be diversified away are not generally compensated for by the market. It may be profitable to invest in this bond on average. However you don’t get the average if you buy just this bond. You either get your money plus 4.5% or nothing. That is a gigantic variance in outcome (variance = risk). If you could buy 100 bonds with this rating from different companies then you could achieve closer to the average outcome and decrease the variance of returns. Since anyone could do that (with enough money) you are taking uncompensated risk by just buying this one bond.


So to answer your question of who is buying this bond, the answer is instituitons that can properly diversify against the risk of default. If you don’t have the money to do that, I recommend buying a fund instead.

fennewaldaj
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by fennewaldaj » Thu Sep 20, 2018 2:55 am

villars wrote:
Wed Sep 19, 2018 10:14 pm
venkman wrote:
Wed Sep 19, 2018 9:47 pm
Right now, the reward just isn't there.

https://fred.stlouisfed.org/series/BAMLC0A4CBBB
I read that all the time on this board. Corporate bonds are not worth the risk, and "take risk on the equity side"

If that is true, wouldn't the lack of demand cause the price of corporate bonds to drop ( ie yield goes up) until they become worth it? In other words how is the average boglehead different from the market at large when it comes to high yield and Corporate bonds?
I think some institutions that are not permitted to own equity (or not own too much) might affect the price of corporate bonds as this is a spot where they can increase their return without breaking rules.

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grabiner
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Re: How likely is it for a corporate bond rated BAA3/BBB to fail?

Post by grabiner » Thu Sep 20, 2018 6:23 pm

Jacobkg wrote:
Thu Sep 20, 2018 1:53 am
Risks that can be diversified away are not generally compensated for by the market. It may be profitable to invest in this bond on average. However you don’t get the average if you buy just this bond. You either get your money plus 4.5% or nothing. That is a gigantic variance in outcome (variance = risk). If you could buy 100 bonds with this rating from different companies then you could achieve closer to the average outcome and decrease the variance of returns. Since anyone could do that (with enough money) you are taking uncompensated risk by just buying this one bond.
And you can do this yourself, by buying a corporate bond ETF. Vanguard Intermediate-Term Corporate ETF (VCIT), for example, holds more than half its holdings in bonds rated BBB, and has a 4.04% yield.
Wiki David Grabiner

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