Investing in Bonds 101: Concepts (cont.)
Part 3 or 3, page 2
Credit Quality
Interest rates on bonds will vary considerably based on the credit quality of the bond issuer. Example, the U.S. Treasury issues securities with a nearly zero risk of non-payment or default. As these securities are backed by the U.S. government, interest payments can always be made by either raising taxes or simply printing more money. Bonds and other securities issued by the U.S. Treasury are considered high quality investments, investment grade bonds.
On the other end of the bond spectrum are companies or corporations which are in default on their bonds. These companies or corporations carry a high degree of credit risk and investing on these bonds is considered speculation. To help describe these risks there are about ten ratings or grades a bond can receive, and even these grades can be subject to a plus or minus modifier.
Bond ratings run from AAA, the highest rating, through D, for bonds in default. There are three bond credit rating agencies: Moody’s, Standard & Poor’s and Fitch Ratings. Each agency has a slightly different system for rating bonds. Typically bonds carrying a rating of BBB, or better, are considered investment quality.
Bonds with a higher credit quality will always carry lower interest rates because the investor assumes less of a risk of default by the issuer. Junk bonds, rated much lower, provide the investor with much higher yields, however the risk of default is much higher.
One note of caution: These rating companies are not always dependable, as we see with the rating of ARM mortgages bundled with less risky loans and rated higher than they should have been. Just as the, pardon the pun, shit hit the fan, ratings companies down graded these investments, but not in time before investor’s lost millions. Also, some bonds have in the past were rated OK, or good, only to fail, as it happened with investor’s who bought foreign bond with high yields. Ratings are not always right, so look behind the bond and do your own research.
Finally
Enough of an introductory on investing in bonds. As you may have observed, the bond market is an efficient market and is therefore an excellent example of the principle of risk and reward. It is hoped that this three-part article will make you more comfortable with adding bond investments to your overall portfolio. If you still feel a bit skiddish, try a bond fund that is managed by a mutual fund and buy some Federal bonds on the side as part of an overall retirement investment.
As with all investing, do your own research and learn all you can before jumping in with both feet. There is nothing wrong with taking it slow, but steady, attitude toward investing. Just keep doing it as it is the only way to build personal wealth.
Fin - The End
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