In this blog post, I'll discuss the probably very well known "credit risk", of bonds.
It is often the case that many people perceive that credit risk is the only kind of risk they are subject to when they invest in bonds, after all, it pains the most when suddenly your entire loan disappears after the other party's insolvency. But a lot of times, even if you buy the lowest rated bonds, the probability of a default is still relatively small. So although credit risk is certainly a type of risk that is worth paying attention to, you should not be completely bogged down by a loan's credit rating.
So, for those of you who don't already know what a credit risk is, it is the risk that, er, whoever you lend to ends up not having enough money to pay you back. In the worst case, they become Chapter 7 bankrupt.
Usually, there are tools that help you determine the credit risk for a particular bond, things called credit ratings. Ratings for large corporates and sovereigns (governments basically) are usually issued by large rating agencies, such as Fitch and Standard & Poor's. These agencies rate bonds based on whatever public information, usually for a fee, for the bonds issuer. The issuer then puts the bonds on the market branded with some kind of rating, ranging from A to D. The rating agencies actually use different rating schemes and A in Fitch may not necessarily mean A in S&P. But as an individual investor, I don’t actually think they matter that much.
Unless you have a couple of millions to throw into this investment business, the chances are, you will not buy individual bonds straight from the issue. Reason being that most bond offerings require a purchases worth at least tens of thousand of dollars. Such big numbers greatly reduces the chance for people like you and I to diversify broadly, as we probably only have that much in total to invest. The reduced diversification is vastly detrimental to a successful investment, but the actual rationale for diversification will be the topic of a separate blog post.
So ordinary folks usually buy bond indirectly from the secondary market in the form of mutual fund or some other kind of aggregate investment vehicle. There are two major advantages of buying a fund of bonds rather than actual bonds. Firstly, you get diversification. Many mutual funds contains a wealth of bonds within, in the order of thousands. For example,
Vanguard Total Bond Market Index Fund has 5230 bonds with different maturities, different credit ratings and different sizes encapsulated. Seconds, the minimum investment requirement is a lot less. Take the same example, the Vanguard funds has a requirement of only 3k, that is probably 1/10 of what you need had you chosen to buy bonds from the original issuers. Of course, you have to pay the expense ratio on a mutual fund, so maybe if you had billions, you can achieve the same diversification without paying that annual 0.22%......
Now, back to credit risk. So I said that credit risk is not as bad as it looks. What I mean is, if you bought a mutual fund like the Total Bond Market Index Fund, with more than 7k bonds encapsulated, defaults are then truly just a statistics. And the good thing about statistics is that now things are predictable. Assuming those ratings are accurate (BIG caveat), then A-rated bonds should not default at all, while C-rated probably will default at 3%. If you simply subtract this percentage from the nominal yield, then you’ll have your expected return! That simple!
Junk bonds are perceived to have the worst credit risk, currently default at around 3-4%. They are not really “junk”, they are just “below investment grade”. Their default rate reached about 10% when Lehman Brothers went bust in the 2008 crisis. But junk bonds are especially sensitive to economic fluctuations since in bad times people try to flee from risky investments to safer ones, and one should not take that as a representation of the entire bond market. Most bonds in other ratings, although still suffered, had their default rate going up only slightly in 2008.
So my take is that credit risk is far easier to control than interest rate risk for bonds with at least investment grade rating (B or higher), and therefore one should pay more attention to the latter rather than being bogged down in choosing between “A”s or “B”s.
And personally, given both risks, I’d invest in intermediate-term investment grade bond funds. They offer OK yield with little credit risk. The bond market is at its historic highs, and interest rate is at a historical low. Intermediate-term bonds have only 5-10 years until maturity, which puts a limit on how much pain there will be when the interest rate starts to eventually go up. Given the Fed has indicated that the low interest rate environment will probably continue until 2014, my guess is that interest rate probably will go up by then.
