By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor

Part 3, Common Risks with Bonds – Credit Risk

I have an old koozie that says, “I never lend money, it causes amnesia.” Since a bond is a loan, the most critical risk is getting your money back. This is called the credit or default risk. The credit risk of a borrower is one of the main drivers of the interest rate on a bond. Just like people with bad credit will pay higher credit card and mortgage interest than people with excellent credit, bonds work in the same way.

And just like there are credit report agencies for individuals that measure an individual’s credit worthiness (Equifax, TransUnion, and Experian), there are several bond rating agencies (Moody’s, Standard & Poor’s, Fitch) that attempt to do the same for bonds.

Instead of an individual’s FICO credit score, bonds are rated in roughly 25 tiers, ranging from AAA/Aaa for the highest, down to Ca/C for the worst. These rating agencies apply a rating to caution investors about the risk of default; that rating also plays a large role in the amount of interest that the borrower will need to pay. More on this later. The credit ratings are divided into essentially two realms. “Investment-grade” bonds are on the high end. Bonds on the low end are euphemistically called “below investment-grade,” optimistically called “high-yield” – and are also known as “junk.” The dividing line with the common Moody’s rating is BBB. Think Better Business Bureau: Anything with an A in the rating in it, plus the BBB rating (the highest of the Bs), is investment grade.

Fun fact:  Bonds are not issued and then rated. They are basically rated, and then issued. For example, a corporation will go to Moody’s and say, “We’re thinking about issuing $100mil in bonds, what rating would you give them?” Moody’s may come back and say something like, “Well you already have $700mil outstanding, these bonds would be BB. But, if you only issue $80mil we could give them a BBB rating …”

The Dutch auctions set interest rates

Interest rates in the United States (and to a certain extent, globally as well) are priced as a function of U.S. Treasury rates. Treasuries are issued about 300 times per year in what is known as a Dutch auction. In a Dutch auction, bidders submit their best price and their desired quantity and then all the highest bidders that can collectively buy the lot win the whole lot issued.

It is an interesting method for selling a lot of items to a relatively small number of bidders at once. You can read more about the process here, but what is important is that this mechanism essentially re-prices U.S. Treasury notes, bills, and bonds frequently. The current interest rate environment is largely based on the last price paid at the last Treasury Dutch auction.

Since the U.S. government can essentially print its way out of debt, holders of U.S. Treasuries are generally not at any risk of default. This is why the interest rate on a U.S. Treasury on any given issue is often called the “risk free rate.”

The reason this is important is that any entity that wants to borrow money with a bond must pay more than its Treasury counterpart or no one will lend them money. If the 10-year Treasury is paying 3% per year, everyone else will need to pay more than 3% on their bonds to entice investors to take on the additional risk of default.

Spreads aren’t just for toast

This additional amount above the Treasury is called the “spread.” High-quality borrowers tend to pay, on average, about 1.5% more than the U.S. government; ergo, if the 10-year Treasury is paying 3% interest per year, a Microsoft or Johnson & Johnson might be able to borrow at 4.5%. That 1.5% spread is often quoted as 150 basis points or “bips” (a basis point is 1/100th of a percent). Low-quality borrowers tend to have spreads of 5% or more.

If the 10-year Treasury is paying 0.6% per year, high-quality bonds only need to pay 2-2.5%, because that same spread is applied to the current U.S. bond interest rate. Low-quality borrowers might pay 5.5-6% interest as a result. This is also why, when the 10-year Treasury is paying 0.6%, you can get a 30-year mortgage with an interest rate of just 3.25%.

Remember, the only reason you can get a 30-year mortgage for 3.25% is because there is someone out there willing to take the other side of that deal.

If you missed my first two segments, you can read them here, Part 1, Bond Basics and Bond Jargon, and here, Part 2, Types of Bonds. In the next post I’ll cover the other primary risk with bond investing: interest rate risk, also known as duration.

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