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Understanding a Bond's Credit Quality
As a bond investor, you're essentially lending money to the issuer of the bond. So you want to make sure the issuer will pay you back, and with interest. Credit quality can be a valuable tool in making that assessment because it refers to the ability of the issuer to make interest and principal payments in full and on time.
Credit quality also has an impact on the interest rate of a bond. Issuers with strong credit quality can pay a lower interest rate because their bonds have a low risk of default. Issuers with weaker credit quality typically pay a higher interest rate to compensate for their greater risk.
Comparing Credit Quality
Using Credit Ratings
Choosing the Right Bond for You
Comparing Credit Quality
When it comes to credit quality, U.S. Treasury bonds are considered the safest bonds available because they are backed by the full faith and credit of the U.S. government.
Bonds issued by government agencies (including government mortgage-backed securities) also are considered very safe investments. Their credit quality typically is one small step below that of Treasury bonds.
That leaves bonds issued by corporations and municipalities (states, cities, counties and their agencies). The credit quality of these bonds can vary from quite high to extremely low, depending on the financial strength of the issuer.
Lower-quality corporate and municipal bonds are known as "high-yield" bonds (commonly called "junk" bonds back in the 1980s). As the name suggests, these bonds offer very high yields — more than 10% on some corporate bonds — because of the greater risk of default
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Using Credit Ratings
The variable credit quality among corporate and municipal bonds points to a need for thorough credit research. But it's not easy to assess the creditworthiness of a bond issuer without an in-depth analysis of the issuer's financial situation and the overall financial environment.
Many investors turn to independent credit rating agencies — such as Standard & Poor's (S&P), Moody's, Fitch and Duff & Phelps — that analyze issuers and rate their bonds. These ratings are based on an assessment of a bond issuer's financial strength, and can be an excellent starting point to determine the creditworthiness of a potential bond investment.
Although the following describes the S&P system, the other major rating agencies use similar indicators in their credit ratings:
- AAA is the highest credit rating and D is the lowest.
- Bonds rated AAA, AA, A and BBB are considered "investment-grade" bonds, which means they are relatively safe from default.
- Bonds rated BB or below (including B, CCC, CC and C) are considered riskier high-yield investments because they have speculative characteristics and may be vulnerable to default.
- Bonds rated D are already in default.
- The ratings may be modified with a plus (+) or a minus (–) to show relative standing within each category.
- It's important to note that credit ratings represent the opinion of the rating agency; they are not absolute standards of quality. Mutual fund companies often have credit analysts of their own, who do additional research before including a bond in a fund's portfolio.
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Choosing the Right Bond for You
As with most investment decisions, choosing the credit quality of your bond investments depends on your risk tolerance and your financial goals. Here are some general tips:
- If you have little or no tolerance for risk, U.S. Treasury and government agency bonds may be the most reassuring choice. You'll get less income than you would from lower-rated bonds, but you will be taking less risk.
- For a little more income with very little additional risk, you may want to consider government-guaranteed mortgage-backed securities such as GNMAs (often called "Ginnie Maes").
- If you want more income and can handle more risk, you may want to consider corporate bonds. Municipal bonds fit into this category as well, although they may be more appropriate for investors in high tax brackets because their interest payments are free from federal income tax.*
- If you're willing to take on even more risk in pursuit of the highest bond yields available, then high-yield corporate or municipal bonds may be the way to go.
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*Interest on municipal bonds may be subject to state and local taxes, as well as the federal Alternative Minimum Tax.
This information is for educational purposes only and is not intended as investment advice.
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