The Basics of Bonds – Credit Risk and Ratings
In last month’s newsletter, we talked about interest risk associated with bond investing. Another significant type of risk associated with bond investing is credit risk. As an investor, you have to be concerned about the bond issuer’s ability to keep paying you the promised interest rate and return your principal at the maturity date. Investors are compensated for assuming credit risk by way of interest payments from the issuer. The higher the perceived credit risk, the higher the interest rate the bond issuer has to offer to investors.
Many investors do not have the expertise to analyze the credit risk of a bond issuer. Therefore, they rely on private credit rating agencies such as Standard & Poor's, Moody's and Fitch. These private agencies provide investors with evaluations of a bond issuer's financial strength, or its ability to pay a bond's principal and interest in a timely fashion.
Each bond will receive a letter rating. To illustrate the bond ratings and their meaning, we'll use the Standard & Poor's format: AAA and AA: High credit-quality investment grade AA and BBB: Medium credit-quality investment grade BB, B, CCC, CC, C: Low credit-quality (non-investment grade), or "junk bonds" D: Bonds in default for non-payment of principal and/or interest
Credit rating can be an effective tool to help investors select bonds with the kind of risk and return profile they are comfortable with. However, investors need to keep in mind that credit ratings are not always reliable. Rating agencies such Moody and Standard & Poor get paid from issuers for whom they issue those ratings, which has led to charges of conflict of interest. Bond issuers have been accused of "shopping" for the best ratings from these three ratings agencies, in order to attract investors, until at least one of the agencies delivers favorable ratings. This arrangement was criticized by some as one of the culprits that caused the 2008 mortgage meltdown.