Understanding Credit Quality and Issuers

Bond investors should keep something in mind: when you lend money to someone, itís nice to get it back.

Bond investors should keep something in mind: when you lend money to someone, it’s nice to get it back.

That’s the simple premise behind understanding credit quality in the world of fixed-income investing. As an investor, it’s important to assess the likelihood that the debt you’ve purchased from a corporation or government will actually be paid back—in full, and on time. When a debt issuer misses a coupon payment—or worse, goes bankrupt—the debt is said to be in default. (Default does not mean that the bonds in question are worthless, just that the terms of the bond aren’t being met.) The likelihood of a credit event actually occurring in the future is referred to as a “probability of default.”

Defaults are relatively rare occurrences, which makes predicting them difficult. The historical record of credit events can be evaluated, but assessing the probability that an issuer will default in the future is something of a dark art.

Still, default risk is a key component to the world of fixed-income investing. Broadly speaking, bonds are broken into two distinct default risk categories: investment grade bonds, which carry lower default risk; and high-yield bonds, which bear higher default risk. (The term “high yield” refers to the higher return that investors expect for investing in bonds with higher credit risk. High-yield bonds are also known as speculative or junk bonds.)

Bond funds often focus on either investment-grade or high-yield issues, and indeed, some investor mandates curtail or prohibit the use of high-yield bonds.

Beyond this bright line between investment grade and high yield, gradations of credit risk within these broad buckets are available in the form of credit ratings. These letter-grade credit ratings are provided by firms like Moody’s and Standard & Poor’s. Indeed, the line between investment grade and high yield is drawn based on the letter-grade credit rating of the bond.

The ratings indicate a bond’s relative creditworthiness. “Relative” means, for example, that a bond rated AAA is less likely to default than a bond rated AA. However, the ratings agencies are increasingly reluctant to say more than this. A studious investor might refer to the historical probability of default that’s associated with a particular credit rating to generate some kind of absolute estimate, but in the end, credit ratings reflect an estimate of relative risk of default, rather than a hard and fast mathematical probability.

Debt issues from both corporations and governments receive credit ratings. For corporations, ratings firms look at financial statements, competitive landscape, management, regulatory issues, the broader economy and other factors. When rating national government debt, ratings firms consider the country’s debt load, demographics, currency stability, monetary and fiscal policy, and political stability.

Note too that bonds from the same issuer might carry different ratings depending on the terms and conditions of the bonds. This might include the investors’ relative place in line among other creditors and the extent to which the debt is backed by assets as collateral.

As you might expect, these factors change over time, which can lead to change in a credit rating, as Moody’s did when it downgraded UK gilts in February 2013.

Clearly, assessing credit risk is a huge, complex task. Unfortunately, the reputation of the credit rating agencies took a major hit in the wake of the 2007-2008 financial crisis after some highly rated bonds defaulted. Critics point out that rating firms are paid by the bond issuers, which creates at least the appearance of a major conflict of interest.

For this reason and others, fixed-income investors often look beyond the credit rating to credit spreads to gauge credit risk. Credit spreads are the different yields offered by bonds of different grades of issuers: A bond rated AAA maturing in 10 years might yield 1%, while the same bond from a BB credit might yield 2%. That spread—the 1% difference—tells you how much the market is demanding to take that extra increment of default risk.

Typically, credit spreads are quotes, as the difference between a UK corporate issues yield a gilt of the same maturity. The idea is that the gilt captures the part of the yield that’s due to inflation, maturity and other factors, and that the difference in yield therefore captures the credit risk for the corporate bond. While this indeed produces an absolute number, credit spreads are useful on a relative basis—whether for comparing the credit spread of one corporate issue to another, or for assessing the direction of movement, such as when spreads tighten, implying that credit risk is decreasing.

As an ETP investor, it’s important to understand which type of risk you’re taking, so evaluating both credit quality (through ratings) and the difference in yield versus gilts is key.