In a previous post, I took a closer look at the significance of duration, which measures the sensitivity of a bond’s price to changes in interest rates. When you buy a bond you take on interest rate risk; the higher the duration the more interest risk you have. You also take on what is known as default risk, which is the risk that the issuer will be unable to fulfill its debt obligations. For today’s post, I’m going to explain how default risk applies to different types of bonds, starting with corporates.
Corporate Bonds and Default Risk
When you buy a corporate bond you are lending money to a corporation, with the understanding that they will make interest payments to you at regular intervals, and then return the principal amount that they borrowed at maturity. Corporate bonds are usually issued at a par value of $1,000 with a stated interest rate known as the coupon. When an investor buys a corporate bond they are primarily taking on 2 kinds of risk – interest rate risk and default risk. The yield an investor receives is compensation for both of these risks. Most investors consider US Treasury debt to be free of default risk, or at least the least likely issuer to default. For this reason people commonly use US Treasury securities as the reference point for measuring a corporate bond’s level of interest rate and default risk. The amount of yield a corporate bond investor receives for taking on interest rate risk will be similar to the yield on a similar maturity Treasury security. The corporate bond investor will then be paid additional yield over and above the comparable Treasury rate; this primarily is for taking on default risk. The riskier the corporate bond issuer, the higher level of additional yield investors will be paid.
Ratings agencies like Standard & Poor’s and Moody’s evaluate the credit quality of bond issuers. Bonds rated BBB-/Baa3 and higher are considered to be investment grade and have a lower default risk than non-investment grade bonds, or “junk bonds” (those with a rating of BB or Ba and lower). The below table shows how the ratings scales of two widely followed rating agencies compare. The table also shows the average additional yield that a bond of a specific credit quality will pay. Not surprisingly, as you move down the table, the yield spreads increase.