Smart Bond Investing—Understanding Risk
Default and Credit Risk
If you have ever loaned money to someone, chances are you gave some thought to the likelihood of being repaid. Some loans are riskier than others. The same is true when you invest in bonds. You are taking a risk that the issuer's promise to repay principal and pay interest on the agreed upon dates and terms will be upheld. While U.S. Treasury securities are generally deemed to be risk-free, most bonds face a possibility of default. This means that the bond obligor will either be late paying creditors (including you, as a bondholder), pay a negotiated reduced amount or, in worst-case scenarios, be unable to pay at all.
Ratings are a way of assessing default and credit risk.
The Securities and Exchange Commission (SEC) has designated 10 rating agencies as Nationally Recognized Statistical Rating Organizations (NRSROs). They are:
- AM Best
- DBRS Ltd.
- Egan-Jones Rating Company
- Fitch Ratings (Fitch)
- Japan Credit Rating Agency, Ltd.
- LACE Financial Corp.
- Moody's Investors Service (Moody's)
- Rating and Investment Information, Inc. (R&I)
- Realpoint LLC, which focuses on commercial mortgage-backed securities; and,
- Standard & Poor's (S&P).
These organizations review information about selected issuers, especially financial information, such as the issuer's financial statements, and assign a rating to an issuer's bonds—from AAA (or Aaa) to D (or no rating).
Each NRSRO uses its own ratings definitions and employs its own criteria for rating a given security. It is entirely possible for the same bond to receive a rating that differs, sometimes substantially, from one ratings agency to the next. While it is a good idea to compare a bond's rating across the various NRSROs, not all bonds are rated by every agency, and some bonds are not rated at all.
Do not make your investment decision based solely on a bond's yield. This is referred to as "reaching for yield," and is one of the most common mistakes bond investors make. See FINRA’s Investor Alert The Grass Isn’t Always Greener—Chasing Return in a Challenging Investment Environment.