August 4, 2004 Tim Anderson, CFA, Chief Fixed Income Strategist Corporate Bond Defaults This month we have decided to take a closer look at credit risk within the corporate bond market. We view credit risk as the largest risk to bond investors. Credit losses, when they occur, are absolute and involve a permanent loss of principal and thus potential future income. Another major risk for fixed income investors, interest-rate risk, can cause the market value of a bond portfolio to decline, but the decline is considered temporary as the investor will still receive par value at maturity and income from the bond remains unaffected. Inflation risk, another important risk factor, involves the loss of purchasing power from your investment, which reduces the real (after inflation) return from your investment, but does not result in the loss of your nominal investment. Implications Even investment grade bonds can exhibit significant default rates. The Advisory Services Group has assembled a team of credit professionals to help support you in your fixed income security selection. Recovery rates are generally less favorable for preferred stocks. In addition, the issuer has the ability to suspend dividend payments (although the investor will still be required to pay phantom income tax on these deferred dividends). Therefore, investors need to receive additional yield over and above the issuer s more senior obligations as compensation for these negative features. Investors in lower rated debt should expect defaults, be diversified to mitigate the impact of those defaults, and make sure that the income received on their bonds is sufficient to compensate for the likely defaults. Understanding default risk is critical when selecting bonds for client portfolios. This is especially true when selecting longer dated corporate bonds, whose prices are much more sensitive than shorter maturity bonds to changes in risk premiums as well as to changes in interest rates. The yield on a corporate bond is determined by the yield on a risk-free benchmark (usually a U.S. Treasury Bond) with a similar maturity plus an additional risk premium yield to compensate the investor for the risk of default and for the severity of loss in the event of default. The riskier a corporate bond is (i.e. the lower its credit rating) the higher the risk premium that the market will typically demand. Yield on a Corporate Bond = Yield on a comparable U.S. Treasury Bond + Risk Premium (%) The chart below demonstrates how the yield on a 5-, 10-, and 30-year corporate bond could be determined for a hypothetical company. Initial Risk Premium Treasury Yield Initial Yield Initial Price XYZ Corp 4.5% 2009 0.70% 3.8%-5 yr 4.5% $100.00 XYZ Corp 5.5% 2014 0.90% 4.6% -10 yr 5.5% $100.00 XYZ Corp 6.5% 2034 1.20% 5.3%-30 yr 6.5% $100.00 The table on the following page illustrates what could happen to the prices of these hypothetical bonds when the market demands an additional 1% risk premium while Treasury yields remain unchanged. The market may demand this additional compensation for risk because of company-specific events (a ratings downgrade, disappointing earnings, etc.) or economic events (recession, falling stock market, etc.). Whatever the rationale, the prices of longer dated corporate bonds tend to be very sensitive to changes in the risk premium. Therefore, the risk premiums for corporate bonds tend to increase as maturities get longer. This is known as the credit curve. The credit curve tends to be steeper for riskier (i.e. lower rated) credits. The higher sensitivity of longer dated corporate bond prices to changes in credit quality and risk premiums highlights the importance of the due diligence process. New Risk Premium Treasury Yield New Yield Old Price New Price XYZ Corp 4.5% 2009 1.70% 3.8% 5.5% $100.00 $95.68 XYZ Corp 5.5% 2014 1.90% 4.6% 6.5% $100.00 $92.73 XYZ Corp 6.5% 2034 2.20% 5.30% 7.5% $100.00 $88.13 Hypothetical results shown for illustrative purposes only; does not represent actual returns on a specific investment. Page 1 of 5
We have reviewed long-term default studies from the two major credit rating agencies, Moody s and Standard & Poor s (S&P). We looked at defaults by rating category and by industry. We have also reviewed the recovery rates (in the event of a default) for specific priorities of claims and specific industries. The chart below shows how the average one-year default rates for investment grade and high yield 1 corporate bonds can vary widely at different points in time. Corporate bonds have historically generated their best relative total returns (price appreciation + income) in years when the default rate has reached a peak and is beginning to improve. For example in 2003 when corporate default rates were falling from extremely high levels, the corporate investment grade market returned 8.3% and the high yield market returned 28.1% (versus +1.3% for the 10-year Treasury Bond). Conversely, corporate bonds tend to have poor relative returns in years where the default rate is increasing rapidly. An example of this is in 2002 when defaults were increasing to record levels, the corporate investment grade market, as represented by the Merrill Lynch Corporate Master Index, returned 10.2%, and the high yield market, as represented by the Merrill Lynch High Yield Master II Index returned 1.9% (versus 14.6% for the 10- year Treasury Bond). These indices are presented to provide you with an understanding of their historic long-term performance and are not presented to illustrate the performance of any security. Investors cannot directly purchase any index. Moody's Annual Default Rate - Investment Grade (1970-2003) 0.60% 0.50% 0.40% 0.30% 0.20% 0.10% 12.00% 1 8.00% 6.00% 4.00% 2.00% 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Moody's Annual Default Rate - High Yield (1970-2003) 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 Page 2 of 5 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1 High-yield bonds, commonly known as junk bonds, are subject to greater risk of loss of principal and interest, including default risk, than higher-rated bonds. Therefore, their prices may be more volatile.
The two charts on this page show the average 1-year and the average cumulative 10-year default rates for corporate bond issuers by rating category. For example, among all bonds rated Baa by Moody s, on average 0.17% would default in any one year and 5.10% would default over a ten-year period. Note that the default rate increases as the credit rating decreases. However, the default rate increases exponentially as the ratings fall below A. The extremely high default rates for lower-rated issuers stresses the importance of diversification and active portfolio management. Moody's Average Annual Default Rate (1970-2003) 3 25.00% 24.53% 2 15.00% 1 6.38% 5.00% 0.02% 0.02% 0.17% 1.20% Aaa Aa A Baa Ba B Caa-C Moody's Average Cumulative 10 Year Default Rate (1970-2003) 9 8 77.97% 7 6 5 50.02% 4 3 2 21.01% 1 0.62% 0.68% 1.59% 5.10% Aaa Aa A Baa Ba B Caa-C Page 3 of 5
The chart below shows the average recovery rates, or what percentage of the initial investment would be recovered in the event of bankruptcy, by priority of claims. As expected, the higher the seniority of the debt, the higher the expected level of recovery. Moody's Average Recovery Rate by Priority of Claims (1982-2003) 7 6 65.1% 62.1% 5 44.7% 51.6% 4 36.1% 3 32.5% 31.1% 24.5% 2 15.3% 1 Bank Loan - Sr Secured Bank Loan - Sr Unsecured Bond - Equipment Trust Secured Unsecured Bond - Bond - Jr Preferred Stock The following chart shows the average default rate by industry. Interestingly, the telecommunications industry has a long-term average default rate of 1.91%, but it was 10.85% in 2001 and 17.83% in 2002. It is very important to know the current trends in particular industries as well as the long term history. S&P Average Annual Default Rate by Industry (1981-2002) 3.5% 3.0% 3.0% 2.5% 2.4% 2.0% 2.1% 2.1% 2.0% 1.9% 1.9% 1.7% 1.5% 1.0% 1.3% 1.0% 0.5% 0.6% 0.6% 0.4% Leisure/Media Consumer/Service Energy/Natural Resources Aerospace/Auto/Cap Goods/Metals Transportation Telecommunications Forest/Bldg prods/homebuilders High Tech/Computers/Office Equipment Healthcare/Chemicals Real Estate Insurance Financial Institutions Utility Page 4 of 5
The following chart shows the average recovery rate by industry. Historically, recovery rates have been higher in industries that have tangible assets and are not burdened with large levels of excess capacity. Keep in mind that past performance is not a gurantee of future performance. Moody's Average Recovery Rate by Industry (1982-2003) 6 51.5% 5 44.5% 42.5% 41.4% 38.8% 38.2% 4 36.6% 36.3% 35.4% 34.4% 34.3% 33.4% 32.7% 32.5% 31.9% 3 29.5% 28.8% 27.4% 23.2% 2 1 Gas Utility Oil/Oil Services Hospitality Electric Utility Ocean Transport Media,Broadcast,Cable Surface Transport Banking/Finance Industrial Retail Air Transport Automotive Healthcare Consumer Goods Construction Technology Real Estate Steel Telecommunications Additional information is available upon request. For further information regarding the content of this report, please contact your financial advisor. While corporate bonds generally have a greater potential return Treasuries, they involve a higher degree of risk. Treasuries, unlike stocks, are guaranteed as to payment of principal and interest by the U.S. government. The investment discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Wachovia Securities does not render legal, accounting or tax advice. Please consult your tax or legal advisors before taking any action that may have tax consequences. This communication is not an offer to sell or solicitation of offers to buy any securities mentioned herein. This report is not a complete analysis of every material fact in respect to any investment or security mentioned. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. Information has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Wachovia Securities is the trade name under which Wachovia Corporation provides brokerage services through two registered broker/dealers: Wachovia Securities, LLC, member NYSE/SIPC, and Wachovia Securities Financial Network, LLC, member NASD/SIPC. Each broker/dealer is a separate non-bank affiliate of Wachovia Corporation. Wachovia Securities, PO Box 1357, Richmond VA 23218 Page 5 of 5