Financial Bonds have Lower Default Rates AND Higher Yields. Here’s Why.

bank bondsThe corporate bond market is split roughly in half between financial issuers (such as banks, brokerage firms, insurers etc) and non-financial issuers. As of the first quarter of 2012, there were $4.8 trillion in financial and $5.2 trillion dollars of non-financial corporate bonds.

These two categories of bonds have widely different yield characteristics, as one might expect.  However what you might not expect is that bank bonds pay a higher yield AND have lower default rates.

Comparison of Default Rates of Financial Versus Nonfinancial Issuers (S&P 1981-2011)

  1 Year Average Default Rate 3 Year Average Default Rate 10 Year Average Default Rate
Financial 0.74% 2.35% 2.35%
Non-Financial 2.03% 5.86% 12.60%

 

The table clearly shows that the default rate for financial issuers is less than half those for non-financial issuers over both 1 and 3 year periods. However, the difference is even more pronounced when looking at the 10 year average.

 

What could explain the difference in default rates between financials and non-financials?

Most financial companies have great credit ratings. Who would do business with a financial company that does not have a great credit rating? Financial transactions almost always involve a high level of trust. For example, a person buying insurance is trusting that insurance company will be able to pay off claims in the future. While this example involves an individual and financial company, the same trust is required when a financial company does business with other companies. As financial companies are both constantly borrowing and making promises of future payment, a financial company with a poor credit history will not find many people willing to do business with it. While all companies are sensitive to credit, non-financial companies do a far greater portion of their transactions on a cash basis, and thus can often grow without having a great credit rating.

Comparison of 5-10 Year Maturity Yields July 26, 2012 (FINRA-TRACE)

  AA A BBB
Financial 4.02% 5.17% 5.88%
Non-Financial 1.66% 1.93% 4.17%

There is a huge difference in yields between between bank bonds and the bonds of other financial companies and non-financial companies, even when adjusting for ratings and maturities. Why?

 

Reason 1: Financial companies crash and burn quickly

When things start heading in the wrong direction for a financial company, there is a quick downward spiral. As soon as the market believes that a financial company is having problems, two things will  happen.

  1. Some firms will stop doing business with the company.
  2. Others will start charging the company more to compensate for the extra perceived credit risk.

As interest rate cost is a major expense for a financial company, the company’s expenses will increase dramatically. Higher cost of capital will in turn hurt the company’s ability to generate income, which will further weaken its financial condition. This will lead to even higher costs and less business. Sometimes, this process can playout over a matter of years and sometimes in a matter of weeks. In the case of Lehman Brothers, the firm went from being the largest bond trading broker in the world to bankruptcy in less than a month.

 

Reason 2: When bank bonds and other types of financial bonds default, there is very little to recover

When a financial service company defaults, the recovery rate (the percentage of principal that is repaid to the debtholders) is very low compared to other industries. The Kansas City Federal Reserve studied the recovery rates for corporate defaults from 1970 and 2008, using data from Moody’s. The overall average recovery rate was 39.3%. For finance, insurance and real-estate companies, the rate was only 24.6% or almost 15% lower. However, half the time when a firm in the category defaults the recovery rate is below 10%, essentially zero.

Why?

Financial companies generally don’t own assets like real-estate, patents, and equipment that can be liquidated. Also in many cases another financial firm cannot gain new clients by purchasing the firm in bankruptcy.  Once a firm loses the markets trust, clients quickly turn to alternative firms.

 

The Bottom Line

Financial firms need to pay higher yields than non-financial companies to compensate for the risk that bondholders will be quickly wiped out and receive almost no money back.  However, given the higher yields paid on financials and lower default rates, an argument can be made that they are still the better investment.

For more on corporate bonds visit the corporate bonds section here at Learn Bonds.

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