Domestic bonds have a reputation for safety (unlike foreign bonds) but investing in bonds is not without risk. You can lose money if you aren’t careful. Inflation risk, interest rate risk, credit risk—these are all real dangers. In this article, we'll talk about the last type: credit risk.
Famed value investor and father of security analysis Benjamin Graham was fond of saying, “More money has been lost reaching for a little extra yield than taken at the barrel of a gun.”
In bond investing, sometimes risk comes from too long a maturity profile, increasing bond duration. More often, it happens that inexperienced investors are attracted to the eye-popping yields available on so-called junk bonds. It's easy to notice only the high-interest rates without considering the correspondingly high probabilities of default. Often, these investors would be better off buying a conservative bond fund or bond index fund that: 1) uses no leverage, and 2) operates at a low cost. By the time they learn this lesson, it's too late.
To increase your odds of successfully protecting your family’s money while generating passive income from bonds, you need to know how credit quality works; specifically, how bond rating agencies classify bonds based on the chance the issuer will default, missing an interest, or principal payment.
When Investing in Bonds, Consider Credit Risk
First, let’s back up for a moment. Whether you are lending money to a friend or to a Fortune 500 corporation, there is a risk that the funds won’t be repaid. Unexpected things happen. There is no avoiding this. For that reason, the stronger the income statement, balance sheet, and cash flow statement of the borrower, the lower the interest rate you are likely to demand, as there is less chance you will be left high and dry. This relationship generally holds true regardless of all other factors, in high-interest-rate environments and low-interest-rate environments.
For municipal bonds, there are several tests of safety you can run to protect your investment. For corporate bonds, you can calculate the credit quality of companies using your own efforts by going through the financial statements and working out things such as the interest coverage ratio or fixed payment coverage ratio. These let you know how much revenue a firm could lose before it is in danger of not generating enough cash to send you what it had promised.
Use Bond Ratings as a Guide
Alternatively, you can pull up the credit ratings for a specific bond from a firm such as Standard & Poor’s, Moody's, or Fitch. These enterprises employ hundreds of analysts who do nothing but calculate such numbers, assigning a letter grade much like the ones you’d receive on a spelling test in elementary school.
Despite some high-profile failures, especially during the subprime crisis, the bond rating agencies have generally done a good job predicting default rates through credit ratings.
Each mainline rating agency is the largely the same in terms of outcome and methodology but for the purposes of this article, we’re going to rely on Standard & Poor’s ranking system. S&P divides bonds into “investment-grade” and “non-investment-grade” using letter grades.
Standard & Poor's Investment-Grade Bond Ratings
Investment-grade bonds are considered safer than other bonds because the resources of the issuers are sufficient to indicate a good capacity to repay obligations.
- AAA = Extremely strong capacity to meet financial commitments.
- AA = Very strong capacity to meet financial commitments.
- A = Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
- BBB = Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.
Non-Investment-Grade Bond Ratings (aka Junk Bonds)
Lower-quality bonds are inherently speculative. There is a decent chance you may not get your principal or interest payments at all, in whole or part. They are especially dangerous when acquired with borrowed money, as has been the fad recently with certain high-yield bond funds that are attempting to make up for low-interest rates by artificially juicing returns.
- BB = Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial, and economic conditions.
- B = More vulnerable to adverse business, financial, and economic conditions but currently has the capacity to meet financial commitments.
- CCC = Currently vulnerable and dependent on favorable business, financial, and economic conditions to meet financial commitments.
- CC = Currently highly vulnerable.
- C = Currently highly vulnerable obligations and other defined circumstances.
- D = Payment default on financial commitments.
Both investment-grade and non-investment-grade bonds rated AAA through CCC can be modified with a plus (+) or minus (-) sign to indicate the relative ranking within its category. For example, AAA+ is considered the highest quality investment-grade bond while BBB- is considered the lowest quality investment-grade bond. Meanwhile, BB+ is considered the highest quality speculative, or junk, bond, while CCC- is considered the lowest quality speculative, or junk, bond.
If you see a bond rated “NR or NA”, that means “Not rated” or “not available.” If you see a bond rated “WD” that means “Rating withdrawn.” There are various reasons this may be the case but if you come across it, it’s probably best to avoid the security.
A primary rule of conservative investing is never acquiring something you don’t fully understand. There are plenty of high-grade, investment-quality bonds available (the bond market is significantly larger than the stock market in terms of aggregate value) so there’s no excuse to make things more complicated than they need to be.
Bond Ratings During Economic Crises
These bond ratings are an excellent predictor of bond credit risk. It is relatively rare for an investment-grade bond to fall into junk bond status. (When this happens, the bond is referred to as a “fallen angel.”) As long as you have a strict policy of selling bonds that fall below your minimum acceptable rating requirement, even if it means triggering a capital loss, you can largely avoid the sorts of horrific experiences you see for people who buy things like penny stocks.
To provide a real-world example of what that means in raw numbers, let’s look at a few historical time periods when the economy was in trouble.
Bond Default Rates During the Great Recession of 2009
In the depth of the Great Recession in 2009, fueled by the subprime and real estate bubbles popping, Wall Street was imploding, Main Street was shedding jobs, and the economy was in a downward spiral. That year, only 0.33% of all investment-grade bonds defaulted. For the worst catastrophe since the Great Depression, that’s phenomenal.
Meanwhile, 9.95% of non-investment-grade bonds defaulted that same year. The higher interest income was illusionary. You might have collected fatter checks for a while but it came at a great cost, often turning momentary profits into losses.
Bond Default Rates During the September 11th, 2001 Crash
In 2001, with the national economy sent into a recession following the attacks in New York, Pennsylvania, and Washington, D.C., 0.23% of investment-grade bonds defaulted compared to 9.90% of non-investment-grade bonds.
Bond Default Rates During the Savings & Loan Crisis of 1991
The recession and aftermath of the S&L crisis in the United States sent defaults on investment-grade bonds to 0.14% and non-investment-grade bonds to 11.05%. The differential between those two numbers is incredible.
Given the rather stark performance gap between investment-grade bonds and non-investment-grade bonds, why do investors keep getting tempted to acquire risky fixed income holdings? They see double-digit interest rate promises and get lulled into a false sense of security by years like 1983, when the default rate on non-investment-grade bonds stood at a mere 2.98%. When the economy is doing well, there is a natural human tendency to extrapolate that into the future and assume it is always going to be doing well.
It’s not that way, of course, and things go south, people lose a lot of money, and the cycle begins all over again. This isn't to say intelligent, financially savvy specialists can't make money in junk bonds—they absolutely can, But, it is the deep end of the pool and 99% of the population has no business swimming there.
What This Means for Average Bond Investors
The moral for the typical bond investor is: Unless you can evaluate individual securities for risk, stick entirely with investment-grade bonds, preferably those rated A or higher. Your yields will be substantially lower but you are far more likely to actually avoid losses caused by a counterparty default. If you’re going to take that sort of risk, there are often far more intelligent ways to do it.