What is a Bond Credit Rating?

Most bonds are assigned a credit rating by one or more of the credit rating agencies, such as Moody's, Standard & Poor's and Fitch Ratings.  The credit rating agencies generally assign letter ratings, which range from  investment grade (i.e. AAA "prime" to BBB "lower-medium grade") to non-investment or junk (i.e. BB "non-investment grade speculative to D "in default").

When a bond issuer wants to assure potential investors that a bond is really and truly safe, they often turn to a bond insurer, also known as a monoline insurer (i.e. Ambac Financial Group, Inc., MBIA).  Bond insurance was very common in the fixed income markets, up until the Credit Crisis of 2008.

What are the Inherent Risks?

Bonds are among the safest investments in the world.  But that hardly means that they’re risk free.  For example, high yielding, lower rated Junk bonds have a high risk of default (issuer's inability to make interest payments or pay back the principal/loan); whereas lower yielding, higher rated U.S. Treasury bonds are essentially riskless.

Here’s a look at some of the inherent risks in bond investing.

• Interest rate risk: When interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. The longer the time to a bond’s maturity, the greater its interest rate risk.

• Reinvestment risk: When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates.

• Inflation risk: Inflation causes tomorrow’s dollar to be worth less than today’s; in other words, it reduces the purchasing power of a bond investor’s future interest payments and principal, collectively known as “cash flows.” Inflation also leads to higher interest rates, which in turn leads to lower bond prices.   Inflation-indexed securities such as Treasury Inflation Protection Securities (TIPS) are structured to remove inflation risk.

• Market risk: The risk that the bond market as a whole would decline, bringing the value of individual securities down with it regardless of their fundamental characteristics.

• Selection risk: The risk that an investor chooses a security that underperforms the market for reasons that cannot be anticipated.

• Timing risk: The risk that an investment performs poorly after its purchase or better after its sale.

• Credit risk: The risk that a borrower will be unable to make interest or principal payments when they are due and therefore default (see also Default Risk).  This risk is minimal for mortgage-backed securities issued by government agencies or government-sponsored enterprises—also known as “agency” securities issued by Ginnie Mae, Fannie Mae or Freddie Mac—and most asset-backed securities, which tend to carry bond insurance that guarantees payments of interest and principal to investors.)

• Default risk: The possibility that a bond issuer will be unable to make interest or principal payments when they are due.  If these payments are not made according to the agreements in the bond documentation, the issuer can default. This risk is minimal for mortgage-backed securities issued by government agencies or government-sponsored enterprises—also known as “agency” securities issued by Ginnie Mae, Fannie Mae or Freddie Mac—and most asset-backed securities, which tend to carry bond insurance that guarantees payments of interest and principal to investors.

• Event risk: The risk that a bond’s issuer undertakes a leveraged buyout, debt restructuring, merger or recapitalization that increases its debt load, causing its bonds’ values to fall, or interferes with its ability to make timely payments of interest and principal. Event risk can also occur due to natural or industrial accidents or regulatory change. (This risk applies more to corporate bonds than municipal bonds.)

• Legislative risk: The risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.

• Call risk: Some corporate, municipal and agency bonds have a “call provision” entitling their issuers to redeem them at a specified price on a date prior to maturity.  Declining interest rates may accelerate the redemption of a callable bond, causing an investor’s principal to be returned sooner than expected.   In that scenario, investors have to reinvest the principal at the lower interest rates (see also Reinvestment risk).  If the bond is called at or close to par value, as is usually the case, investors who paid a premium for their bond also risk a loss of principal. In reality, prices of callable bonds are unlikely to move much above the call price if lower interest rates make the bond likely to be called.

• Liquidity risk: The risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value.  Liquidity risk is greater for thinly traded securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit rating downgraded or bonds sold by an infrequent issuer.  Bonds are generally the most liquid during the period right after issuance when the typical bond has the highest trading volume.