The Corporate Bond Market: Often Misunderstood and Underappreciated

corporate bond marketThis 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.

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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.

Junk vs. Investment Grade Bond Market Size Comparison

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.)

global junk vs. investment grade bond market sizes

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.

Ratings Makeup

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.

bond market number of issuers globally

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.

us junk bond market issuers

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.

chart 6

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.

Screen shot 2013-08-07 at 10.07.43 AM

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.

Screen shot 2013-08-07 at 10.08.39 AM

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.

(Comments are desired, but I do not guarantee their publication.  If your comment[s] indicates that you did not read and genuinely consider the all of the article’s contents, I may not publish it; or I may remove it.  You do not need to agree; but do not be derogatory.  The comment section is meant for legitimate questions or concerns and well-intended discussion.)

About Kurt Shrout

Screen shot 2013-08-07 at 10.09.57 AMKurt 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.

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Comments

  1. Withheld says

    Thank you for the interesting research article. In my view the most likely reasons that global credit quality is in secular decline (as well as cyclical) are 1) Lower interest rates – people reaching for yield and 2) the declining global economies, especially Europe.

    • Kurt Shrout says

      In the years leading up to 1983 (but not before then), public (non-private-issue) corporate junk bonds were very largely or almost entirely fallen angels (i.e., bonds that were originally investment grade, but that had fallen in credit quality). It was impossible or difficult to do a public junk bond issuance. The junk bond market has developed greatly since then, basically because enough people realized that there was a lot of money to be made holding and underwriting junk bonds. The most influential of these people was Michael Milken (who worked for Drexel Burnham Lambert at the time). This is the main reason for the secular trend. That said, it does seem like the about 30-year bull market (generally falling interest rates) for bonds and recently weaker global economies had to have contributed positively to the secular and cyclical trends. (I have seen evidence of this.) P.S., Your name and associated email address, although funny, will offend some people. I changed your name to “Withheld”. Your email address is not visible on the website to people not affiliated with LearnBonds.

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