Risk Management – Default Risk
Investors don’t normally think of themselves as lenders – banks do the lending right? Not always. If you have any kind of bonds or mutual funds, closed-end funds or ETFs that own bonds, you are a lender. Not in the direct sense. You don’t have a contract with the borrower to be repaid, for example – unless you own a government or corporate bond directly.
During the 2008 financial crisis, the word default was a household term. People were defaulting on mortgages, companies were defaulting on their bonds, some companies, like Lehman Brothers, couldn’t get a loan because they were viewed as a high default risk.
There are a couple of points to remember. The first is that return needs to be commensurate with the risk involved. Oftentimes the market might indicate which instruments are perceived as more ‘risky’ – they’ll have higher yields than other comparably rated instruments. Debt is nearly always rated. There are various ratings agencies. Standard & Poors, Moody’s, and Fitch are three of the major agencies. They all have a different nomenclature for their grading, but it’s the same as your report card.
A is the best, B second-best, and so forth. You should see yields increase as you look at lower-rated bonds. There is a fairly significant misconception right now. People seem to think that because the government and/or fed are bailing everything out that there is no longer any default risk. Again, this is not simply an American circumstance, this is more global. So simply shifting bond purchases to overseas companies won’t necessarily help.
The big advantage of holding a bond over a stock is that 1) you’re going to get some type of interest even if it is small. Companies may or may not pay a dividend on their common stock. Generally the preferred shares, which are hybrids and have characteristics of both stocks and bonds also have interest. The second big advantage to owning debt is that you’re a creditor of the company. If there IS a bankruptcy, the bondholders and other creditors are first in line for any distribution of the company’s assets. Stocks are considered equity.
Keep in mind that a default and a bankruptcy are two different events. A default is when the borrow stops paying on a particular loan or multiple loans. While a default is an alarming development, it doesn’t necessarily equal a bankruptcy in which the company either is permitted to re-organize or goes out of business altogether. So if you own bonds from a particular company and that company goes bust, you might get some of your capital back, but almost certainly not all of it. If you’re a shareholder in a company and the company goes broke, it is extremely unlikely to have any return of capital.
When considering the risk of default it is always good to look at a company’s balance sheet and several years worth of income statements at a bare minimum. A SWOT analysis is also helpful. What sorts of events might result in your company not having money to make good on its debts? What is going on right now is certainly going to cause problems. What other types of events could hurt your company? We would encourage people to stay away from the assumption that industries and companies will always be bailed out by governments. After all, investors and creditors in Lehman Brothers, didn’t think the USGovt would leave the company twisting in the wind.
There are some very important lessons to be learned by studying economic and financial history with the goal being to learn from the mistakes of others rather than having to endure the pain of defaults in your own portfolio.
Sutton/Mehl