Bond default risk varies greatly by sector
4 Mar 2013 by Jim Fickett.
If you buy individual bonds rather than investing in a bond fund, it is worth paying attention to statistics on sector quality. Fitch has just released an interesting report entitled, The Impact of Industry Selection on Default Risk (free subscription required), in which they point out a rather extreme contrast: Over the period 1980 to 2013, the worst five sectors produced an average annual default rate of 13.9%, while the best 20 sectors produced a default rate of 1.8%.
Over that period, the worst five sectors were
- Telecommunications
- Banking and finance
- Automotive
- Transportation
- Textiles and furniture
The worst five over the past 33 years might not be the wort five in the next few decades. Fitch recommend watching for a number of red flags in a sector, including
- Overbuilding (in particular an increase in the fraction of the total high-yield market devoted to that sector)
- Obsolescence
- Cyclicality
- Decline in ratings
In particular, although energy has been one of the safer sectors historically, there has been very clear overbuilding recently, with 19% of new high-yield issuance devoted to energy in 2012. This is probably closely related to the fact that oil and gas production from shale has grown at unsustainable rates, and is unprofitable in many cases.
The Fitch report mentions that cheap money often leads to higher default rates later. I have mentioned before that interest in bonds with the lowest rating – CCC – has grown as investors seek yield wherever they can find it. The foolishness of current low yields is particularly evident in CCC bonds. CCC yields have recently been about 11% but in recessions the CCC default rate rises, on average, to about 35%.
