Bonds – High Yield vs. Investment Grade
Global bonds are a very popular choice of investment for local investors seeking fixed income options and are a good alternative to the stock market. These bonds are primarily issued by governments and corporations as a means of borrowing funds for the short (maximum 1 year) to the long term depending on their needs. They will specify a rate of interest which is normally payable quarterly, half-yearly or annually along with a maturity date. The rate of interest payable (coupon rate) is dependent on the corporation’s credit risk i.e. the probability of their defaulting on the loan. That risk is assessed by credit rating agencies such as Standard and Poor’s, Moody’s and Fitch. Corporations with strong financials/fundamentals and a good outlook for the future are normally the corporations that will get a better rating as they are considered less risky than those that fall short in those areas.
Naturally the old maxim of higher risk, higher reward then comes into play as those corporations with a high/good credit rating are more likely to attract investors to purchase their bonds as their probability of default in repayment of the debt will be significantly lower than lower-rated corporations. This rating will enable them to raise funds at a lower cost than corporations that have a low credit rating. The latter corporations will have to offer higher rates in order to attract investors to take on that risk because of the higher probability of default. The bond credit rating given by these rating agencies is what is used to determine whether a bond is investment grade or high yield/junk bond. The following chart shows the comparison of the three major rating agencies’ credit rating grades and credit quality. It highlights the distinction between investment grade and high yield/junk bonds which are at the opposite spectrum of the chart.
This is very important to investors, and from the table, investment grade bonds will have ratings on Standard & Poor’s (S&P) from a high of AAA to a low of BBB-. You will also note that their credit quality on the Moody’s scale ranges from minimal credit risk to moderate credit risk. On the other hand, high yield/junk bonds range from BB+ to a low of D and the credit quality from substantial credit risk to in default, with little chance of recovery.
It is important for investors to take the time to understand these fundamentals if they are considering investing in bonds and if they are unsure, then they should take the time to ask their investment manager to explain it to them. Each individual will have a different risk appetite and although a bond may fall into the junk category, it does not necessarily mean that the corporation will not honour their financial obligations. The higher yield on these bonds is an opportunity for investors seeking a higher rate of return to consider having some bonds in this category in their portfolio. This, of course, will be after they have weighed very carefully, what percentage of their investment portfolio they will be comfortable placing in this category of bonds that will ensure that they do not have sleepless nights!
Ian Watson is Vice President, Sales & Marketing at Sterling Asset Management Ltd. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: [email protected] or visit our website at www.sterling.com.jm