Corporate bonds, or financial obligations owed by companies, have been increasingly year on year for a long time now. A few months ago, a fellow investor pointed out to me the growing issue not just of net bond values in issue, but the grade of those bonds.
How are bonds graded?
Bonds – both corporate and municipal – are rated by rating agencies. These organisations are paid to present investors with a qualified, informed, and independent opinion on the likelihood that the company issuing the bond will be able to repay it. To calculate this, the ratings agencies collect information on market conditions, the company’s balance sheet, income statements, key clients, trading history, and also it’s prior history of repaying financial obligations. The agencies then review this information and convert it into a rating – one for the company and one for each bond. These ratings run from ‘AAA’ down to ‘D’, with the former being extremely safe, with a very low likelihood of default, and anything below ‘BBB-‘ being considered ‘junk’ or at significant risk of default.
The main agencies are Moody’s, Standard and Poor’s, and Fitch – each of whom have a slightly different set of rankings. For example, Moody’s uses a numerical indicator and Fitch uses a + or – to indicate quality within a category.
Investors that hold ‘junk’ bonds generally need to have a higher risk tolerance than those holding investment grade bonds, but because the financial health of an issuer can change, the ratings of bonds sometimes change whilst being repaid, making it important to monitor the values attributed to your bonds.
So what’s the problem with the bond market?
My fellow investor was concerned at the volume of sub investment-grade bonds in issuance and being placed into ‘investment-grade’ bond indexes. A recent article by Bloomberg indicated that BBB-rated bonds now comprise more than 50% of all debt in the US in addition to that category having also more than tripled in value.
Some of the larger bond funds buy a small amount of all bonds in existence. In theory, this diversification protects the holders of the fund. But if a larger and larger percentage of that fund is taken up by BBB rated bonds at a time when the economy is supposedly doing well – what do you think will happen when the economy enters a recession?
Simply put – nothing good.
Buying low grade credit is a risky business. Investors chase the yield premium paid out by the lower grades of investment bond and often collect a healthy premium for holding them. The price ricochets around, but long-term bond holders simply hold to maturity. It all seems great – until one day, that ‘risk’ the company has to pay a premium to compensate for crystalises and it starts to struggle to repay its debt.
The bondholders begin to sell of their bonds, the prices collapse and investors who thought they had a ‘safe’ investment end up taking huge capital losses (especially if the issuers go bankrupt).
So I ask you the question…how many times have you heard that bonds are a ‘safe’ investment again?