In fixed-income investing, it’s important to understand two key factors that drive bond prices, and, in turn, fixed-income investment performance. The first is interest rates: When rates rise, bond prices typically fall.
Then there’s credit risk—will the company, government, or municipality that issued a bond remain financially strong enough to make interest payments in a timely manner and repay the principal in full by the bond’s maturity date?
When the economy appears to be healthy, credit risks often command little attention from fixed-income investors relative to interest rates. That’s because most borrowers are likely to be in a better financial position to meet their credit obligations when times are good than when things go south. Yet credit issues can affect fixed-income performance even in strong economies, as noneconomic factors—not just economic ones—may cause the finances of companies, governments, and municipalities to weaken or even collapse.
One challenge for fixed-income investors is that the creditworthiness of a borrower isn’t necessarily easy to determine. In the case of corporate bonds, the broad market is constantly reassessing each borrower’s creditworthiness—resulting in changes to bond prices and yields—and those changing perceptions are influenced by the credit ratings assigned to the company issuing the debt. These ratings affect both the income that a bond may generate for the investor and the borrowing costs that the issuer will pay.
But where do these ratings come from, and what do they mean for investors in bonds and bond mutual funds? Here are four things to know about credit ratings.
1 Ratings give market participants a baseline for assessing risk
While ratings are comparable to credit scores that help determine an individual consumer’s borrowing costs, the creditworthiness of a corporation or a federal, state, or municipal government is much more complex. That’s where rating agencies come in; they’ve got plenty of resources and expertise, and are charged with independently, thoroughly, and impartially reviewing corporate and government issuers’ credit risks. These firms take a deep dive into debt issuers’ abilities to meet their obligations, in full and on time.
While ratings constitute opinions on issuers’ creditworthiness and the relative risks of default, they’re by no means guarantees; unforeseeable events ranging from natural disasters to unanticipated legal exposure can quickly undercut an issuer’s seemingly sound financial position. And it’s important to remember that, for all the expertise that the rating agencies have at their disposal, their creditworthiness judgments are made by teams of individuals who are human and, therefore, fallible. At times, their ratings may under- or overstate an issuer’s true risk level.
Three agencies dominate the U.S. credit ratings industry: Standard & Poor’s Global Ratings, Moody’s Investors Service, and Fitch Ratings. While there are differences in naming conventions, the firms’ rating scales are similar, with breakpoints at which each firm categorizes bonds as either investment grade, indicating a relatively low risk of default, or non-investment grade, also known as high-yield or speculative debt, or by the disparaging term junk bonds.
Long-term bond credit rating scales of the three major U.S. rating agencies
2 A debt issuer's credit rating can have a major impact on borrowing costs—and an investor's income
An issuer with a high rating will pay much less in borrowing costs, reflected by the interest rates paid, than a low-rated issuer, due to the relatively lower risk involved. It follows, then, that an investor may expect greater income in exchange for the higher risk involved in low-rated debt. Relative to highly rated debt, lower-rated bonds will typically carry a higher coupon rate—the annual payments from the issuer to the investor relative to the bond’s value on the date it was originally issued. For a comparison of yields—which change as the value of the bond changes owing to market price movements—consider that as of mid-April 2019, yields on low-rated high-yield debt averaged nearly 3.7%, while investment-grade debt with comparable duration to maturity carried average yield of less than 1.2%.2
As for U.S. government debt, it carries ratings near the top of the rating agencies’ scales— owing in part to the government’s pledge that its borrowing is backed by its “full faith and credit.” As a result, government debt typically offers lower yields than investments in comparable debt in the corporate market.
3 Below investment-grade debt or other low-rated debt isn't necessarily bad from an investment standpoint
While low-rated debt necessarily carries higher credit risks than highly rated debt, the income advantage that lower-rated debt offers may better align with some investors’ portfolio objectives than higher-grade debt. As with much of investing, it’s a trade-off between risk and return. For example, an investor may be reluctant to make an allocation to equities because of the potential risks—historically, stock market volatility has been greater than fixed-income volatility. However, many lower-yielding fixed-income options, such as short-term U.S. Treasury bonds, may not meet an investor’s needs for long-term growth potential. A middle ground between those two options could be an allocation to high-yield bonds, which may generate higher returns than government debt with lower volatility than stocks.
4 Investing in bond mutual funds rather than individual bonds may help manage credit risks
For most investors, a fixed-income allocation serves as the ballast in a diversified portfolio, helping to offset equities’ higher volatility. Entering retirement, investors generally become more risk averse as they shift from accumulating savings to drawing them down—a phase of life when ill-timed market losses have the potential to significantly diminish income and erode savings.
Given the potential risk mitigation role that bonds are intended to play in most portfolios, any loss triggered by a bond issuer’s default could be particularly painful if the investor’s holding in that bond issue was substantial. Such a risk—however, remote—is one reason why there may be advantages to investing in a bond mutual fund rather than holding an individual bond. Even with the availability of credit ratings, it’s no simple task for an individual investor to research whether a bond is attractively priced relative to its credit risks and other potential pitfalls, such as rising interest rates or inflation. Bond funds typically hold diversified portfolios of hundreds of bonds. If just a single issuer defaults, the impact on the fund’s overall portfolio may likely be modest. The fund’s portfolio manager assesses factors such as credit risk, taking into consideration not only a bond’s credit rating, but also other variables that the portfolio manager may believe hasn’t been factored into that rating.
1 “Next Debt Crisis: Will Liquidity Hold?” S&P Global Ratings, March 12, 2019. 2 Federal Reserve Bank of St. Louis, as of 4/17/19.