Zaks Investment Advisory Service

Bonds: Credit Risk

Last time, we started discussing bonds: who issues them, who buys them, and how they differ from stocks. I mentioned that bonds and stocks belong to different asset classes. The factors affecting the risk of stocks and bonds are different: they have different “risk profiles.” When we assess the risk of stocks, we for the most part assume the investment risk and the market risk. But when we speak of the risk affecting bonds, we must for the most part pay attention to the interest rate risk (risk associated with interest rate fluctuations), inflation risk, and credit risk (or default risk). Let us begin with the relatively simple credit risk.

We said that when buying bonds, the investor turns into a creditor and the company issuing the bonds – a debtor. Almost every time you lend somebody money, there is a possibility, albeit small, that this money will not be returned. The exception is our federal government: it can always raise taxes, so we can rest assured that its debts will be paid. Companies issuing bonds assume the obligation of paying back the bond’s coupon and principal. However, we know that financial circumstances sometimes add up to force a company into bankruptcy (the same thing, but rarely, happens to municipalities – for example, to the City of New York in the 1970s). In these situations, a judge takes over the company’s finances and all of its creditors line up at the door. Company employees are the first to get paid – they get their owed wages. The company then pays all its taxes. If there is still money left after that, it pays back the bondholders. Sometimes, when there is little money left, creditors receive a small percentage of what they are owed. After that (again, if there is anything left), money is distributed between the so-called unsecured creditors – the company’s suppliers, for example. And, very last of all, the money goes to shareholders. Usually, by this point, the money runs out and the shareholders get zilch.

One of the fundamental financial principles postulates that the riskier the bond, the less its market price. Imagine that you had a choice between buying two bonds. Both have the same date of maturity (say, July 22, 2020) and the same coupon – say, six percent. But one of the bonds was issued by General Electric, and the other – by a small, little-known company that sells computers. Let us call it Acme Electronics. Both companies’ bonds promise the exact same return: for every $1,000 of the nominal cost – two yearly payments of $30 through 2020, and then $1,000 of the original principal. Which bond would you be willing to pay more for? Of course, the one issued by General Electric. The probability that it will meet its commitments and pay off the coupon and then the principal is very high. On the other hand, there is a chance that something might happen to Acme Electronics over the next 13 years, and we demand an additional return for the higher risk. For this reason, General Electric bonds would be quoted higher on the market than those of Acme Electronics.

Usually, it is fairly difficult for the individual investor to value the risk of specific bonds. There are several companies that help investors do this. The main ones are Standard & Poor’s, Moody’s, and Fitch. Each of the three has its own scale system. At S&P, for example, the highest-quality bonds (i.e. those that stand the least chance of not meeting their obligations) are denoted by three As (AAA). Then come AA, A, etc. Moody’s uses a similar system. The bonds are traditionally separated into two risk groups: investment grade bonds and junk bonds. Some financial companies may not invest in junk bonds (this is usually determined by internal regulations, which must be followed). Thus, in certain cases, the rating a bond earns from S&P or Moody’s becomes a matter of principle. For example, after Russia’s 1998 financial collapse, when the bonds issued by the Russian Federation came into default, all subsequent bonds issued by Russia earned junk bond ratings. They could not be purchased by many financial companies. Five years later, Moody’s raised its rating for Russia to investment class, and Standard and Poor’s followed suit another year-and-a-half later. Now, many investment funds purchase Russian bonds.

Unfortunately, one cannot fully trust companies that earn creditworthy ratings. You probably remember the infamous Enron case. Five days before Enron declared bankruptcy, some companies still held its rating at investment grade. And just recently, some of them came under a deluge of criticism for placing too high a rating on companies that finance the so-called subprime mortgages – about which you must have heard plenty over the past few days.

Our time is up. Next time, we will talk about interest rates and their risk. I would like to remind our listeners that on the Portfolios page of our site www.zaksinvest.com, we provide information about three model portfolios, and compare their performance to that of the market. Compare the return of your investments to our model portfolios. If you do not know what the return of your portfolio is, contact us and we will calculate it for you. This was Sergey Zaks. Thank you for your attention and until next time.