Investors often turn to corporate bonds to earn higher rates on cash lent, but what about risk?
For many people, corporate bonds are the first things that come to mind when they think about fixed income. After all, corporate bonds are the debt counterpart to corporate equity, better known as stocks.
From the issuing firm’s point of view, corporate debt is riskier for them compared with stock, simply because the investor’s money must be repaid with interest. If they believe in the growth story of a firm, stockholders are often content to go years or even decades without dividends. Bondholders demand interest, and should the unthinkable happen—bankruptcy—they’re among the first in line to get paid. That’s why, from an investor point of view, fixed income investing is generally less risky than equity investing.
The “first cut” in assessing the risk for corporate bonds is whether an issuer is considered investment grade or high yield (sometimes called junk). In fact, most corporate indices draw this distinction quite plainly, and hold either one or the other. Because risk characteristics can change over time, a bond can occasionally move from one classification to the other, which will ultimately result in its addition or subtraction from an index.
But who decides whether a bond is investment grade or high yield, and how?
The investment community relies on the services of credit rating agencies to monitor the financial health of bond issuers, usually providing a letter grade for each individual bond issue. The ratings firms analyze the issuing firm on many levels, with a focus on the overall likelihood that the firm will pay all interest and principal on the note. They look at the firm’s financial health, including outstanding debt and debt payments, sales, earnings, cash, assets and other factors. They consider a firm’s place in the competitive landscape and the stage of its development (young growth firm or mature cash cow). They also look at the sector in which the firm operates, the broader economy and the business cycle. Aspects of the particular bond issue also matter, such as where creditors of the issue stand in line in case of default. Differences in bond covenants can cause bonds from the same issuer to have different ratings.
All of these factors and more are rolled up into a single letter grade from the rating firm, such as AA- or Baa. Ratings agencies use different systems, but they share a few elements in common. First, credit ratings offer a relative assessment of risk, rather than an absolute one. This simply means that a bond rated AA- is less risky than one rated AA. Tables exist that show how defaults have occurred historically for each bond within a specific rating, but defaults are generally few and far between—particularly above the junkiest of junk bonds—which makes projecting the values into the future more dubious.
The point is that while ratings for corporate bonds are widely used, or at least referred to, they are ultimately just estimates. The accuracy of these estimates was tested—and in many cases came up short—in the 2007/2008 financial crisis, leaving many investors skeptical of the ratings’ utility.
Still, a bond’s letter grade determines whether it lands in an investment-grade (less risky) index or a (riskier) high-yield index. Guidelines for some individuals and institutions specify investment grade only. Still, investors of all stripes have flocked to products that track high-yield indices for the income they can generate.
Corporate bond investors also consider credit spreads when evaluating credit risk.
(See “Understanding Credit Quality And Issuers.”)
Aside from credit risk, geographic coverage also plays a huge role in shaping corporate bond indices. Investors have no shortage of choices here. Global indices include developed as well as emerging markets, though they are typically dominated by the former. Developed-markets indices screen out emerging countries and vice versa. Regional and single-country indices exist too.
Note, however, that geography doesn’t always convey the currency in which the bonds are issued. For example, some emerging market corporate bonds are issued in US dollars, and indices often include those bonds in a US index because of that. Additionally, some indices hedge currency exposure, though not necessarily into sterling.
Regarding maturity, most UK investors using index-based corporate bond ETFs are limited to broad maturity funds. Still, a handful of ETFs will focus on short- or long-dated corporate bonds.
Within the bounds described above, most corporate bond indices select and weight by market value; that is, individual issues with larger amounts outstanding receive greater weight.
Last, it’s worth noting that corporate bonds can often be much more illiquid than sovereign bonds. Because of this, some indices will select bonds specifically based on liquidity, while some ETFs will hold a more liquid version of a bond than might be listed in the index. Because an ETF can become more liquid than the bonds it holds, or trade at different times of the day, differences can occur between the market price of the bond fund and the index it tracks, making for some tricky times in assessing the “fair” value of corporate bond ETFs. (See “Why Do Bond ETFs Have Large Premiums and Discounts?” for more information.)
Ultimately, corporate bonds are often a great solution for investors seeking income, but it’s important to keep the risks and rewards in perspective.