In the most dismal economic decade of the century, defaults of high grade bonds, those rated Aaa and Aa, were negligible. Not one Aaa bond defaulted and Aa bonds had a 0.30% annual default rate. Even bonds at the lower end of the investment grade, rated A and Baa, averaged respective annual default rates of 0.59% and 1.13%. In retrospect, it appears that investors, seized by fear, overestimated the risk of default and those prepared to venture out of Treasuries were handsomely compensated.
So far, default rates for 2008 and 2009 suggest that the default experience for quality bonds, although elevated, will be much less severe than the 1930's (see Appendix II at the end of this Commentary). Even today's bears are not forecasting a second downturn as severe as the recession of 1938 when nominal GDP plummeted 6.3% from the prior year. In fact, a recent Standard & Poor's report estimated the forward looking one year default rate for U.S. bonds at just 0.075%.
The Congressional Budget Office forecasts that the U.S. government will incur nearly 10 trillion dollars in additional deficits from 2011 to 2020. Annual budget deficits are not expected to fall below 4% of GDP and will be growing toward the end of the decade as ever-rising interest payments take their toll. In contrast, according to a recent Standard & Poor's report, cash and short-term investments for non-financial S&P 500 companies have grown over 40% over the past two years to nearly a trillion dollars, equivalent to 40.1% of corporate debt.
Investors looking for a deflationary hedge should not simply run to Treasuries. The winner in the 1930's was high grade bonds – they just might offer that same opportunity today.
Appendix I
Annual Issuer-Weighted Corporate Default Rates by Credit Rating 1930-39
Source: Moody's Investor Services, Corporate Defaults and Recovery Rates, 1920-2009
Appendix II
Annual Issuer-Weighted Corporate Default Rates by Credit Rating 2008-2009
Source: Moody's Investor Services, Corporate Defaults and Recovery Rates, 1920-2009
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