This is the first article in a multipart series regarding corporate bonds. The end goal is to convey a much more accurate understanding of corporate bond default losses and what return you should expect on corporate bond investments. First, though, I will cover some more basic material to make certain that we better understand the corporate bond market.
The corporate bond market is often misunderstood. One way in which the corporate bond market is misunderstood is that many people think that the U.S. corporate junk (non-investment-grade) bond market has been growing in size in recent decades in relation to the U.S. corporate bond market as a whole. As you will see, this impression, in dollars versus number-of-issuers terms, is false. Also, many people do not fully understand the fundamentals of corporate bond default loss risk. There are other misunderstandings as well.
Corporate bonds (and municipal bonds) are underappreciated because there is a greater relative interest in bond investments for which the chance of default losses is non-existent or close to it (e.g., Treasuries). Corporate bonds (or municipal bonds, depending upon your tax situation and other factors) are, generally, better purchases. However, correctly evaluating corporate bond purchases requires greater sophistication and effort. You need to understand the different credit ratings involved (i.e., AAA/Aaa, AA/Aa, A…) and what default losses are likely to be associated with these credit ratings; and, if you are going to purchase individual bonds versus a bond fund(s), you need to be able to evaluate a company’s financial situation and business prospects.
Junk vs. Non-Junk
Below is a chart showing the size of the U.S. corporate junk bond market versus the size of the U.S. corporate bond market as a whole from the end of 1990 to the end of 2012. The chart presents the situation in terms of nominal-GDP-adjusted 2012 dollars. The junk bond market figures are somewhat approximate since I estimated the pre-nominal-GDP-adjusted figures by using a graphic within a recent Fitch Ratings report. Nonetheless, the end results are plenty accurate for our purpose here. Notice that the U.S. corporate junk bond market is currently about the same size as it has been since 1990 in relation to the U.S. corporate bond market as a whole. In fact, it is currently near the lower end of its 1990-2012 size range.
The dollar figures in the chart above were adjusted to be in 2012-nominal-GDP dollars. For example, the unadjusted figures for 1990 were $210 and $1,350 billion respectively. Adjusting by nominal GDP adjusts for both inflation and growth of the economy.
Below is a chart showing the size of the global corporate junk bond market versus the size of the global corporate bond market as a whole from the start of 1970 to the start of 2012. The chart presents the situation in terms of the number of issuers. Notice that on a number-of-issuers basis the global corporate junk bond market has been growing in size in relation to the global corporate bond market as a whole. The data in the chart reflects the issuers in Moody’s Investors Service’s annual cohorts and does not represent all issuers. (Standard & Poor’s [S&P’s] like global report lists a much higher number of issuers.)
The data in the two charts above seems to be inconsistent, but it is not. Lower-credit-quality corporate bond issuers are, on average, much smaller borrowers than higher-credit-quality corporate bond issuers; so you have more issuers and a lower dollar value at the lower credit qualities. Also, there has been a trend toward lower credit quality within the corporate junk bond space (See the Ratings Makeup section below.) that contributes to the seeming inconsistency. Furthermore, the U.S. data only goes back to 1990; whereas the global data goes back to 1970.
Below is a chart showing how the global corporate bond market has changed in terms of credit quality over time. Notice how Caa-to-C and B issuers have greatly grown in relative prevalence and Ba issuers have largely decreased in relative prevalence. The makeup of the global corporate junk bond market is not nearly what it used to be. This is important to know. Statistics showing overall corporate junk bond defaults or default losses from the past are largely deceptive in that they reflect a market that was, once, of much higher credit quality. To understand what overall default losses we should expect going forward, we need to analyze on a more micro level.
Below is the credit quality makeup of the U.S. corporate junk bond market today in terms of dollars. Like the global corporate junk bond market, the U.S. corporate junk bond market is of much lower credit quality today than it used to be.
If we combine the immediately above data with (1) the S&P and Moody’s ratings data for the PIMCO Investment-Grade Corporate Bond Index ETF and (2) the junk and overall corporate bond market size data for the end of 2012 at the beginning of this article, we get the following picture of the entire U.S. corporate bond market.
Below is a view of the global corporate bond market by credit rating provided by S&P. The view is in terms of number of issuers, so the junk bond percentages are much higher than in the pie chart immediately above. Notice that European Union (EU) issuers tend to be of higher credit quality than is usual and emerging markets issuers tend to be of lower credit quality than is usual.
You should have noticed in the chart above that the number of CCC-to-C issuers is rather low. S&P assigns very few CCC-to-C ratings, as you can see in the chart below.
Default Loss Risk Fundamentals
In the next article in this series, I will cover the fundamentals of corporate bond default loss risk. Until then, good luck in your investing.
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About Kurt Shrout
Kurt has a BA and MA in Communication and over 20 years of business experience, almost always serving as a project or program manager, director, or consultant or as an analyst. He lived and worked in many different locations in the U.S., London, England, and Hong Kong. He has experience in at least 18 different industries and 31 different enterprises. Although he was only 49, he essentially retired in 2008 and began spending a lot more time studying investing. His articles are largely written as a public service. They provide investors with a rare totally unbiased view of the investing landscape and often include unique analysis. You can read more of his articles by clicking here.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.