Sunday, March 29, 2009

why your principal investment will always be safe in bonds

Not just government bonds either.
Look at the statistics.
It's difficult to find hard data on the default rate of corporate bonds. They exist in two categories :

1) Investment-grade- meaning the highest ratings for a company's ability to pay back the debt on time with uninterrupted interest payments.
2) High-yield or Junk Bonds- meaning experts, analysts and investors have significant and/or legitimate doubts or concerns about the bond issuer's ability to pay back the debt and/or interest to all the bondholders at the specified dates.

Government of Canada bonds should likely be considered the safest place to protect your money on the face of the earth right now, even more so than US treasury notes.

However, i have looked and from what i can read about the American fixed-income market (i assume the data from Canada wouldn't be wildly different, but beware the difference), the statistics for high-yield, or junk bonds, are as follows:

In good years, the pessimistic estimate on junk bond default rates is one out of every three bonds that is available in the open market will default during the course of a year.

This view is contrasted with several other studies which analyze the data based on slightly different criteria and estimate that in times of relative stability and growth, junk bonds actually default at a rate of around 2-3%. Meaning about one out of every fifty junk bonds in the market during the course of a year will default.

Estimates for this year, based on the economic meltdown have predicted the default rate of junk bonds to be anywhere from 10%-30% for 2009-2010. No one really knows for sure, and the estimate was first around 30% and more recently revised downward to about 10-15%.

From this information, the conclusion can be reached that junk bonds are speculative and perhaps depend largely on the stability of the economy to avoid default.

I'm not posting a source for this info because you should not take my word for it and find out the real risk of a corporate bond defaulting for yourself. I believe this is an accurate estimate only and an outfit like Standard & Poor's should likely have some data- just search "corporate bond default rates" in Google- you will find some reliable (meaning peer-reviewed or widely syndicated) information. It will take searching, so be patient and filter out the misinformation and marketing ploys.

As for investment-grade corporate bonds? What are their typical default rates?
Well, from what i have read, it is typically much, much lower than the default rate of junk bonds.
How low? well, it all depends on the company you decide to purchase a bond from. But the numbers are basically .1% to .01% according to the conservative and optimistic research, respectively.

No investment has a 100% guarantee. Not even the government of Canada can say that absolutely a government of Canada bond is 100% safe. An asteroid could strike the earth, a massive synchronized global terror attack could take out every financial centre on earth, nuclear war could break out. All those terrible, largely unpredicatble and unstoppable events (meaning once it's coming you can't stop it, just try to run and hide) could easily force the Canadian and American governments into default.

What about deposit insurance on a GIC? It's the same concept. If the system fails, the insurance system will fail. If the government defaults, the government insurance agency will likely be forced to do the same thing.
If you read carefully about the FDIC in the USA, during the height of this crisis it was actually, technically on the brink of insolvency. Place that argument in context- it is very, very, very, very unlikely to happen. but nothing is impossible- absolute 100% guarantees on your principal simply do not exist when it comes to investing (or life in general but that's another matter)

But consider also, that some governments that issue bonds and some companies that offer corporate bonds are considered at such a low risk of default (either because of a stable, growing revenue stream or because the company already sits on a great deal of assets) that if you buy one of their bond issues there will be essentially NO RISK OF DEFAULT! More accurately, you will have essentially the same risk of default in an investment-grade corporate bond as you will in a government bond.

Many corporations that issue bonds actually have more revenue and assets than some countries that do not default on their loans. Remember, Wal-mart is one of the biggest economies in the world. Investment-grade companies make it a corporate habit to always honour their debts first and foremost. It's how and why they get the title 'investment-grade' in the first place.

Again, you need to look for yourself to find this information. Don't take my word for it. Or better yet, prove me wrong. I believe the above statements reflect the past, present and likely near and distant future economic reality for investors in the investment-grade corporate, provincial and municipal bond markets.

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