Thursday, 23 October 2008

Seeking Safety: Assessing Default Risk

How safe is safe? The current market turmoil and the spectre of numerous failed, acquired and bailed-out banks in the US, the UK and Europe, though not in Canada, raises questions about the safety of investments, even those considered the least risky.

When looking for "safe" investments, most people have in their minds whether or not the invested capital and any interest owing will be paid back, which is termed credit or default risk. But any guarantee is only as good as the strength and reputation of the party making it, which may or may not be the institution where you invested the money. So what are the assurances or guarantees and who are the backers for some common securities?

Equities are very high risk in terms of default risk since no one makes any promise to pay anything back.

Brokerage Account Cash - the industry-funded body Canadian Investor Protection Fund (CIPF) promises to reimburse investors up to $1 million in cash (or other holdings) per account at member companies in case of their insolvency. This includes US dollars or other foreign currency, unlike CDIC coverage. At the end of 2007, CIPF had over $500 million available, which seems like a lot but it has to cover $1.3 trillion of assets at brokerages, most of which is invested in federal and provincial bonds. Is that enough? Since 1969 CIPF has had to pay out only $36 million in total. Is that past a guide to the present? The FAQ answers many questions about coverage.

T-Bills, Federal/Provincial Savings Bonds, Real Return Bonds, Federal/Provincial Bonds - their safety all depend on the credit-worthiness of the federal or individual provincial governments. And they are not all the same. In addition, there are numerous federal and provincial agencies and crown corporations (e.g. Ontario Hydro) issuing bonds and their riskiness is unique to each organisation.

Corporate Bonds - they all depend on the strength of the individual company but are almost always below government bonds.

Obviously, it is impossible for any investor to keep track of and perform risk assessments on all these issuers. Enter the ...

Credit Rating Agencies - companies that assign credit ratings on the issuers of debt as well as the obligations themselves. The main ones are:
Each has a number of classes according to the level of risk but they may give different ratings for the same organisation - after all it is estimation of what will happen in the future and there is judgment involved. Despite their best efforts they can be wrong. The government of Canada's is in the very best class but various provinces are rated lower, though still considered to be high quality. DBRS rates the City of Montreal the same as Enbridge Pipelines at A+ (high).

Like many things in life, safety is a relative and shifting measure.

1 comment:

Anonymous said...

Hi, I can’t understand how to add your site in my rss reader. Can you Help me, please :)