Bonds receive a credit score, just like you do
A credit score can be thought of as a grade for how responsibly you’ve managed debt. We all receive a credit score, and lenders often use this number to determine how likely we are to repay loans. That’s right — our entire credit history can be summed up in a few measly numbers! Similarly, companies and, more specifically, the bonds they issue, have credit ratings that determine how likely investors (like you) are to be repaid.
Credit ratings estimate a bond’s risk level
When you buy a corporate bond, you’re essentially lending the company money, which can be used to finance a company’s operations, fund a new project, to roll-over older bonds that are maturing, and much more. In return, you usually earn interest and then receive your original principal amount back when the bond matures. Credit ratings are important to investors because they reflect the market’s estimation of the “riskiness” of a bond, which in turn determines how much interest needs to be paid by the bond to make it an attractive investment. Of course, you want to make sure you’re repaid – this is where credit ratings come in.
Ratings can range from AAA to D
Most credit ratings come from one of three companies: Moody’s, Standard & Poor’s and Fitch. Ratings range from AAA for the “safest” bonds all the way down to D which represents bonds already in default – meaning the issuing company can’t repay them. As an investor, it’s important to be familiar with the terms “investment grade,” which represents high-quality bonds, and “high-yield” which represents riskier bonds that pay higher interest rates as a result. An S&P rating of BBB-, or the equivalent rating from the other ratings agencies, is the cut off for investment grade bonds.
Diversification helps reduce risk
It's harder for individual investors to buy individual bonds, because there are minimum purchase sizes. The markets are often dominated by institutional investors, who buy large amounts of bonds. This can make purchasing a single bond more expensive and difficult for individual investors. Instead, they may choose to buy bond funds, which allow for diversification across hundreds or even thousands of different bonds. This reduces risk because even if one bond defaults due to circumstances specific to that particular company, there are still many others in the fund. What should matter to you is that the overall bond fund is of a certain quality and provides a certain amount of income. Investors can incorporate these bond funds in their portfolios as a way to diversify and balance out other types of investments such as stocks.
Investing in a variety of bonds is good for your portfolio
It’s important to understand how credit ratings relate to the riskiness of a bond. Both investment grade and high yield bonds are important asset classes in portfolios, and can be sources of income when included in your portfolio.