Investing 101: Credit Risk

In my Investing 101: Bonds post, I referred to two types of risk inherent in owning bonds; interest rate risk, which is the risk that interest rates will change and therefore change the value of your bond holdings, and credit risk, which is the risk that the issuer of the bond won’t make their scheduled payments. While with US Treasury bonds you are only exposed to interest rate risk, with bonds that are issued by anyone other than the US Treasury you are also exposed to credit risk.

Credit risk is measured by rating agencies. Moody’s and Standard and Poors are the two most prominent rating agencies. A letter rating is assigned to bond issuers, though not all bonds are officially rated. The highest rating is AAA, while the lowest rating is D, as in “default”. Ratings from AAA to BBB are considered investment grade, because the issuer is highly likely to make the scheduled payments. Ratings from BB to D are considered speculative. Whether the issuer pays is a gamble, and in the case of D rated bonds, the issuer has already failed to make a payment or violated some other requirement in their bond contract.

Each issuer has their own market interest rate, based on their perceived credit risk, with better rated issuers having lower interest rates. The current average single A ten year corporate bond rate is 3.48%. The ten year US Treasury rate is 2.18%. The difference of 1.30% is the average additional return the bond market requires to take on the credit risk of an A rated issuer. The average triple B rated bond interest rate is 3.98%, 0.50% higher than the A rated bonds. The average rate on speculative grade bonds is currently 7.08%, more than double the interest rate on A rated bonds. The additional interest required for credit risk is called the spread.

The spread associated with different perceived credit risks is fluid, changing daily as the market assesses the overall risk to creditors in the environment as well as with each individual issuer. The impact on bond prices of a change in spread is exactly the same as the impact due to changes in Treasury interest rates. When the spread widens for an issuer and Treasury rates are stable, the overall interest rate for that issuer rises and the price of their bonds decline. When the spread narrows, the bond price increases.

You are most likely to see investment grade bond mutual funds in your employer sponsored retirement plan. There are a limited number of pure Treasury mutual funds, and even government bond mutual funds have municipal or government agency bonds that do have some credit risk. Most consider the additional yield provided by investment grade issuers to be worth the additional risk.

Some plans also offer a “high yield” bond fund. High yield bond funds invest in speculative grade bonds. Speculative grade bonds can seem very attractive given the much higher interest rates, but beware. Speculative grade bonds present a similar level of risk as equities, and in fact tend to perform more in line with equities than investment grade bonds. If you want to increase your investment returns, a better route is to simply add stocks.

The bond funds available to you in your plan may also include “short term”, “intermediate term” or “long term” in the title. These terms refer to the interest rate risk associated with the fund, with short term bond funds generally holding bonds with maturities of three years or less, intermediate bond funds holding bonds with maturities of four to ten years and long term bond funds holding bonds with more than ten years to maturity . However, credit risk also declines with time to maturity. Shorter term investment grade bonds have less credit risk (and credit spread) than intermediate term investment grade bonds. This is simply because there is less time for things to go wrong for the underlying issuers.

This may seem complex, but in many respects bonds are more homogeneous than stocks, with the primary driver of changes in values being changes in US Treasury interest rates and time remaining to maturity. Credit risk is an important concept, but in general, if your investments are in investment grade bond mutual funds, the credit risk of any single issuer will have little impact on your results.

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