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Bonds Credit Rating Explained
A credit rating is the graduation of the ability of the issuer to comply with its obligation of paying the interests and the principal on a determined date. Independent rating services evaluate the credit risk of municipal and corporate bonds. A financially strong company or municipality generally has low business and financial risk.
Moody’s and Standard & Poor’s (S&P) 500 tow of the most renowned rating agencies and their ratings are similar , but not equal.
Ratings of AAA, AA, A and BBB from S&P are considered as investment-grade quality. Bonds with a level lower than BBB are considered as junk bonds and are speculative. Since these junk bonds have lower ratings, their issuers tend more to default their interests and principal repayments. These ratings only provide those possible investors in bonds of a related guide to assist them because the financial statement of an issuer can deteriorate with time and the bonds fall into a lower rating. A downgrading generally causes a decline in the market over bond prices. The opposite occurs when a bonds issue is upgraded.
The same issuer with many different issues of bonds outstanding can have different ratings for each issue.
You should not be so worried if your bonds are downgraded from AAA to A, because this level still indicates a good quality. Nevertheless if an issue is downgraded to lower than BBB you should review whether to continue owning that bond.
You should minimize the credit risks when buying good quality bonds with A ratings or above which have a reduced option of being defaulted and through the diversification of their investments. In other words, before investing all your money in bonds from a same issuer buy bonds from different issuers and different sectors of the bond market.
A call risk is the risk that an issued bond can be called before its maturity. Bonds with a call provision have a call risk. Many issued bonds by corporations and municipalities have a call provision, allowing issuers to re-buy their bonds at a specific call price before its maturity which benefits the issuer but not the investor.
When the interest rates decline less than the bonds coupon rate in some percentage points, the issuer will most certainly will call in the bonds. The issuer then will reissue new bonds at a lower coupon rate. A call risk causes the investors a potential loss in the principal since bonds are bought at a premium price that is higher than the call price. You should anticipate the call risk by the estimated level to which interest rates would fall before the issuer deems convenient calling the issue.
The callable bonds are not as advantageous as non-callable bonds. Consequently a callable bond with the same risk level and same characteristics can be negotiated at a lower price (higher yield) than a non-callable bond.
To minimize the call risk you should examine the call provision of the bond and choose bonds that are less probable of being called. This advise is particularly important for anyone who is thinking of purchasing bonds that are being negotiated over their par values (at a premium).
The purchasing-power risk is the risk in which inflation could erosion the returns of the owned bonds. The purchasing-power risk is an expected change in inflation that reduces the real return rate of investors.
The purchasing-power risk occurs during inflation periods that affect prices of bonds. Since bond interest payments are generally fixed the value of payments are affected by inflation. When the inflation rates goes up the prices of bonds fall due to the acquisition power of coupon payments received are reduced.
To fight the purchasing-power risk you should invest in bonds whose return rates exceed those of inflation to come. If you anticipate a future inflation invest in floating rate bonds and Treasury inflation protection securities whose coupon rates are readjusted according to market interest rates and inflation rates.
The reinvestment-rate risk is the risk that received payments of an investment could be reinvested at a lower return rate. All the coupon bonds are subject to reinvestment-rate risk.
Interest payments received could be reinvested at a lower interest rate than those of coupon rates of your bonds, particularly if the markets interest rates decline or have declined.
The zero-coupon bonds which generate periodical payments of interest do not have a reinvestment risk.
Liquidity risk is the risk that develops when selling an investment at a significant concession price in relation to the market price.
A bondholder that usually sell bonds always takes the risk when making significant concessions in price in relation to market prices.
The risk prevails for those bonds that have not been negotiated actively, where large spreads occur between demand and supply. Therefore, if liquidity is important you should invest in actively traded bonds.
Have in mind that bonds are not liquid investments as money-market securities are.