Tuesday, 19 July 2011

Investing Risk: Default or, How often do investments go belly up?

Greece has been much in the news lately, scaring investors and governments around the world at the prospect that it will default on its debt. The fright is no surprise as default - not paying money back as promised - is perhaps the most serious and devastating risk an investor can face. But what are the facts? Often fear of the unknown is worse than the real threat itself. This week we therefore try to reduce the unknown and pose the question: what are the chances of default for bonds and stocks, and does default necessarily mean complete loss of funds or has there been some money recovered afterwards?

Governments - Greece's predicament is not an isolated incident. Governments around the world have a habit of issuing more debt than they can pay back. University professors Carmen Reinhart and Kenneth Rogoff have looked at records going back hundreds of years. They tell us in Eight Hundred Years of Financial Folly, from which comes the chart below, that there are periods of high financial stress when 40% or more of countries are in default or restructuring their debt.

A Canadian investor mulling over such statistics is no doubt grateful that the most likely destination for their investments, the debt of the federal and various Canadian provincial governments, has not yet seen a default, though the provinces do not enjoy the very highest triple A / lowest likelihood of default rating enjoyed by the federal government. For those interested, a search of ratings agency DBRS for each province will reveal the ratings for each province.

Corporate Bonds - Periodic peaks of defaults also bedevil corporate bonds, especially amongst bonds rated speculative or below investment grade. The chart below from the Credit Suisse Global Investment Returns Yearbook 2011 shows spikes in default rates nearing 6% at times in recent decades.

Speculative grades of corporate bonds show highly variable default cycles. In some years, like 2005, there have been no defaults. In other years, like 1989 and 1990, defaults have spiked upwards to extreme levels - up to 50% default rates, as bond rater Moody's shows in Default and Recovery Rates of Canadian Corporate Bond Issuers 1989 - 2005. Investment grade bonds on the other hand, have been quite stable and have stayed at very low default rates. Of course, that can be deceiving. Buying only investment grade bonds does not necessarily ensure safety, as the rating agencies quickly change their ratings downwards as problems mount at companies so that by the time of default the bonds are no longer investment grade.

Recovery Rates - The same Moody's document mentions the significant fact that all is not automatically lost when a default occurs. Recovery rates vary by the bond's priority of claim. As one would expect, bonds with higher priority have higher recovery rates on average. Senior secured bondholders got 54% of their money back over the 1989 to 2005 period, while senior unsecured bondholders only managed to recover 36.5% (see Exhibit 9 for all the rates by categories). Moody's also states that US and Canadian recovery rates are roughly similar.

Equities - Stockholders are residual owners, having a claim to assets upon default only after all other claimholders have been satisfied. It is seldom that anything is left over for stockholders when a company goes bankrupt. What is more, life for the vast majority businesses is short, much shorter than that of humans. According to the Business Week article The Lifespan of a Company, the average Fortune 500 company only lasts 40 to 50 years. Moreover, the Fortune 500 consists of large successful corporations and thus represents more winners than losers. United Capital Funding's post Small Business Survival Rates in the United States, cites various US government sources that indicate only about a quarter of small businesses last even 15 years.

The situation in Canada is much the same. Though statistics and studies are hard to find, consider the following. In our comparison of the top 25 stocks in the TSX index between 1995 and 2009, we found that about half had disappeared. In the entire TSX index, only about a quarter of the companies from 1995 still appear in 2011. Not all were eliminated in spectacular bankruptcies like Air Canada, Nortel and Canwest that completely wiped out stock value, but a number did. When a company weakens over time and is eventually acquired by another, often the stock will have declined considerably to a tiny fraction of the peak value. This latter kind of "default" loss of capital takes place over months or years.

In short, default risk has been and continues to be a critical risk, requiring the investor's close attention and indicating a serious need for countering action.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

No comments: