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Default Rate

The default rate is the percentage of bond issuers that default on their obligations within a specified period (typically one year). Default rates vary significantly by credit rating, economic cycle, and industry. Investment-grade default rates are typically under 1% annually; high-yield default rates are 2–4% in normal periods but can spike to 8%+ in severe recessions.

For recovery after default, see recovery rate. For credit ratings predicting defaults, see credit rating. For credit risk generally, see credit spread.

Default rates by rating

Empirical default rates (historical averages):

  • AAA — 0.0% (rarely defaults)
  • AA — 0.1% (extremely rare)
  • A — 0.2–0.3%
  • BBB — 0.5–1.0%
  • BB — 1.5–2.5%
  • B — 4–6%
  • CCC and below — 15–25%

These are long-term averages. Annual rates vary significantly with economic conditions.

Cyclicality and recession impact

Default rates are highly cyclical:

  • Expansion (2003–2007 pre-crisis) — High-yield default rates < 1%
  • Recession (2008–2009) — Default rates spiked to 12% for high-yield
  • Recovery (2010–2019) — Default rates fell back to 2–3%
  • Crisis (2020 pandemic, brief) — Default rates rose sharply
  • Expansion (2021–2023) — Default rates normalized

The pattern is clear: strong economies produce low defaults; weak economies produce high defaults.

Correlation and systemic risk

Default rates are correlated — when one company defaults, others are likely to follow. This is called default clustering:

  • In booms, most companies are profitable; defaults are idiosyncratic (one company’s misfortune)
  • In recessions, many companies face difficulty; defaults are systematic (many fail together)

A portfolio of high-yield bonds spread across 100 companies might experience 2% defaults (2 companies) in a boom but 10% defaults (10 companies) in a severe recession. This correlation is not diversifiable and creates systemic risk.

Measuring and tracking

Moody’s publishes annual “Speculative Grade Default and Recovery Study” tracking default rates by rating and industry. S&P publishes similar data.

These studies show:

  • 1-year default rate — % defaulting within 12 months
  • Cumulative default rate — % defaulting within 5 years or entire life of bonds
  • Recovery rates — What percentage of face value is recovered post-default

Recovery rate

Recovery rate is what investors recover after default, expressed as a percentage of face value. A bond defaulting and recovering 40 cents on the dollar has a 40% recovery rate.

Recovery rates depend on:

  1. Seniority — Senior unsecured bonds recover more (~50–60%) than subordinated bonds (~20–30%)
  2. Collateral — Secured bonds (with collateral) recover more than unsecured
  3. Business value — Strong companies with valuable assets recover more
  4. Restructuring vs. liquidation — Restructured companies often preserve value; liquidations lose value

The expected loss for a bond is: Default probability × (100% - recovery rate)

If a bond has a 5% default probability and 40% recovery rate, expected loss is 3% (5% × 60%).

Loss given default (LGD)

Loss given default is the percentage lost if default occurs (100% minus recovery). For bonds recovering 40%, LGD is 60%.

LGD varies widely:

  • Senior secured — 20–30% LGD
  • Senior unsecured — 40–50% LGD
  • Subordinated — 60–70% LGD
  • Equity — 100% LGD (total loss)

Credit risk and expected return

Credit spreads must compensate for default risk. A bond with 5% default probability and 40% recovery needs at least a 3% spread (expected loss) to break even. Markets typically demand more (4–6%+) to compensate for volatility and uncertainty.

When default rates are low (expansions), investors underestimate risk and accept tight spreads. When default rates spike (recessions), investors demand wider spreads, and bond prices fall.

Prediction and management

Credit analysts attempt to predict defaults by analyzing:

  • Financial metrics — Leverage, coverage ratios, profitability trends
  • Market signals — Credit spreads, credit ratings, equity price
  • Industry trends — Demand, competition, regulatory environment
  • Management quality — Competence, track record, incentive alignment

Careful credit analysis can identify companies likely to default before market prices reflect it, creating investment opportunities.

See also

Wider context