This is “Credit Risk”, section 9.2 from the book Finance for Managers (v. 0.1).
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Not all bonds are created equal. For example, which seems like the safer investment: loan $1,000 to the US government, or loan $1,000 to a small company that hasn’t paid interest to its current investors for over a year? Investing in the world’s largest economy probably seems like the better bet, all other things being equal. But what if the small company offered you three or four times the return on your investment? Now the decision is not so straightforward….
The major difference between our government bond and the small company’s bond is our expectation of the borrower’s creditworthiness. We label the uncertainty in future cash flows due to possibility that the borrower will not pay credit riskThe uncertainty in future cash flows due to possibility that the borrower will not pay.. The most common credit risk is default riskThe most common credit risk, which in the extreme occurs when the company doesn’t have the cash to pay the necessary scheduled payment (or chooses not to)., which in the extreme occurs when the company doesn’t have the cash to pay the necessary scheduled payment (or chooses not to). This is not the only reason; bonds can be determined to be in default for breeching specific covenants (for example, a covenant specifying that certain liquidity ratios be maintained), even if all payments have been made.
Since, as of the time of this writing, the US government is the largest government on Earth with the largest potential revenue stream, it has been considered the borrower with the least amount of credit risk. While not truly without credit risk (in 1979, for instance, the US government was late in a small portion of its debt payments, due to a supposed paper error!), as a proxy, we consider US government bonds to be the “risk-free” asset, in terms of credit risk.
Sometimes, credit risk can be reduced through the use of collateralAssets pledged to secure repayment., or assets pledged to secure repayment. The most familiar collateral arrangement is the standard home mortgage, where the property itself is collateral against the amount borrowed. Corporations can also pledge certain assets when they choose to issue bonds, with the anticipation that the lower credit risk will correspond to a lower cost of borrowing.
To aid investors in their assessment of the credit risk of bond issuers, there exist ratings agencies which attempt to qualify the creditworthiness of each bond issue. Some of the larger agencies include: Standard and Poor’s (S&P), Moody’s, and Fitch. Ratings range from AAA (or Aaa, as different agencies have slightly different scales) for the most creditworthy debt, to D for debt that is already in default. Bonds rated at least BBB− (or Baa3) are considered “investment grade”, which can be an important distinction for many mutual funds that invest in bonds to allow the bonds to be held in their portfolios. Any bonds rated lower (BB+/Ba1 or below) are considered not investment grade, or “speculative”. These bonds are sometimes called “junk bonds” as well (though it would be important to remember that even “junk bonds” have a higher claim on a company’s assets than any shares of stock).
Table 9.1 Bond Ratings
|High Grade||Aaa to Aa3||AAA to AA−||AAA to AA−|
|Medium Grade||A1 to Baa3||A+ to BBB−||A+ to BBB−|
|Speculative||Ba1 to B3||BB+ to B−||BB+ to B−|
|Very Risky or In Default||Caa1 to C||CCC+ to D||CCC to D|
There have been some concerns over the accuracy of the ratings provided by these providers, especially after the credit crisis of 2008. Some highly rated securities ended up having default rates much higher than would have been expected, given their assigned ratings. One argument is that these securities were so complex that the ratings agencies couldn’t accurately evaluate them. Another claim was that, since ratings agencies earn their revenues by charging for assigning a rating to a security’s issue, there is a potential conflict of interest that encourages the agencies to give higher ratings than they otherwise should. Regardless of the cause, confidence in ratings agencies has been shaken, and, while the information provided by such companies is undoubtedly useful, an investor is wise to not blindly take ratings as absolute truth, especially when more complex instruments are involved.