Bond Default Rates

Dec 14, 2014 by

Bonds are rated by Moody’s, S&P, and Fitch, based on their perceived risk of default. Each of the raters uses a slightly different set of ratings. The ratings (borrow from Wikipedia) are:

Moody’s S&P Fitch Description
Long-term Short-term Long-term Short-term Long-term Short-term
Aaa P-1 AAA A-1+ AAA F1+ Prime
Aa1 AA+ AA+ High grade
Aa3 AA− AA−
A1 A+ A-1 A+ F1 Upper medium grade
A2 A A
A3 P-2 A− A-2 A− F2
Baa1 BBB+ BBB+ Lower medium grade
Baa2 P-3 BBB A-3 BBB F3
Baa3 BBB− BBB−
Ba1 Not prime BB+ B BB+ B Non-investment grade
Ba3 BB− BB−
B1 B+ B+ Highly speculative
B2 B B
B3 B− B−
Caa1 CCC+ C CCC C Substantial risks
Caa2 CCC Extremely speculative
Caa3 CCC− Default imminent with little
prospect for recovery
C D / DDD / In default

Bonds rated B1/B+/B+ or lower are often called “junk” bonds, while those with a higher ratings are “investment grade” bonds. That being said, default rates are actually a lot lower than one might expect. From 2010 – 2012, there was only a single investment-grade default. While 14 investment-grade defaults occurred in 2008 and 11 in 2009, only 5 investment-grade defaults occurred between 2003 and 2007. When defaults do occur, they are often preceded by credit rating downgrades.

From 1981 to 2012, the default rates of bonds were as follows:

Bond Default Rates, 1981 - 2012

Bond Default Rates, 1981 – 2012 (Click to expand.) Source: NACT

The average default rate for B+ bonds (high-end junk bonds) was only 2.36% per year. Things get truly dicey with the CCC/C bonds, which had an average default rate of 23.53%. To put things in perspective, if one held a B+ bond for five years and it had the average likelihood of defaulting each year, there is an 88.7% one would not experience a default over the five year span. Yes, this represents a degree of risk. However, given that some of the investment may be recovered in the event of a default, it may be even smaller than it seems.

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