Bonds #2 - Credit Risk

The initial article about bonds ended with four advantages:

· Safety

· Diversity

· Income

· Growth

So, start at the beginning, Alice. The issue of “safety” can also be viewed as the balance of risk and reward. This concept is a little more complicated than “no pain, no gain”. And the topic of risk tolerance includes more than the ability to gamble without qualms!

We need to be aware of the main types of risk in bond investing and the ways we can manage that risk to achieve our goals.

· Credit risk

· Interest rate risk

· Reinvestment risk

· Inflation

CREDIT RISK

When you buy a bond you want to be sure that, not only do you receive your interest payments on time and in full, but that the face amount will be paid back at maturity. Default risk can be managed by looking at the credit worthiness of the issuer. Two rating services make this fairly simple for us --Moody’s Investor Services and Standard & Poor’s.

For long-range planning, I prefer only to look at the ratings classified as investment-grade. From highest to lowest, these reflect the issuers’ ability to repay principal and interest.

The strongest rating is Aaa from Moody’s or AAA by S&P.

The best example is the U.S. Treasury, deemed to be the safest investment in the world. Of course, the government does not have to entice you with the highest yields on these bonds, as there is essentially no credit risk.

Government agencies also carry a AAA rating, but may not be formally backed by the “full faith and credit” of the U.S. Treasury, so they will have to offer a higher yield than Treasury bonds. This difference in yield is called the “spread above Treasuries”. If a ten-year Treasury currently yields 6.40% and an agency bond maturing in ten years will pay you 6.90%, then you are earning an additional ½% or 50 basis points “over Treasuries”. In dollar terms, a $10,000 investment would earn an additional $50 per year, or $500 over the ten years to maturity date. Both bonds would pay back the $10,000 face amount at maturity.

There are a few triple-A corporations in the U.S. and overseas markets. Bonds issued by these high quality companies will have a yield higher than government agencies, because their financial status could erode over time. In this case, they could be downgraded by the rating agencies.

Next is Aa / AA with a “very strong capacity” to repay principal and interest, followed by A / A “strong capacity” and by Baa / BBB or “adequate capacity”.

Corporate issuers can be in any line of business (telephones, manufacturers, utilities, banks, etc). The outlook for these industries, as well as the individual company, affects the issuer’s credit rating. Again, the weaker names (in these strong categories) have higher yields.

Bonds with ratings below investment grade are termed speculative and have even wider spreads above Treasury yields. Speculative ratings start with Ba / BB and run down to C (not making interest payments) to D (in default of principal repayment).

On a relative basis, my clients are more interested in the “return of their money” rather than the “return on their money”. I only invest in Investment-Grade issues for them. In my personal retirement account, this is doubly true.

But does this care in the selection of high-quality issuers protect me from all risk? Of course not!