What are the risks of buying bonds?
There are a few things to think about. Some bonds can be “called” early, meaning that the issuer can repurchase the bonds and there’s nothing you can do about it. The issuer might do this when interest rates have fallen because it can issue new bonds at a lower (read: cheaper) rate. As an investor, that’s bad news because it means you won’t get the future coupon payments, reducing the overall value of the bond.
Interest rates going up poses a less obvious risk but might cost you nonetheless. You might be stuck holding a bond that pays a 2% coupon when you could be getting 3-4% returns elsewhere. If this happens, the price of the bond is likely to fall and the yield rise – meaning you’ll make a loss if you sell.
The scariest risk of them all is your bond defaulting. If a company entirely runs out of money and declares bankruptcy, it might not be able to pay back its existing debts – so it will default on the bonds, and you’ll be left out of pocket. Or, even if a company doesn’t go entirely broke, it might be forced to skip a coupon payment or two to preserve cash.
Sounds scary. 👻 How do I protect myself?
Fortunately, there are organisations called credit-rating agencies – the most well-known are Standard & Poor’s, Moody’s, and Fitch – which try to assess the likelihood of a company defaulting on its bonds, by assigning a score to the company’s bonds. For example, for Standard and Poor’s, AAA is the top rating, AA the next best, and so on. (There are slight variations in the way each agency writes its scores, annoyingly).
The scales ⚖️ go all the way down to C, and only about half of the ratings count as “investment grade” bonds. Below the cut-off point, you’re dealing with “non-investment grade” or “junk” bonds: they might pay a really high rate, but they’re much riskier.
The agencies are pretty thorough and look at a bunch of factors when deciding how creditworthy 💳 a company is: including financial data, strategy, and the general economic and competitive environment in which the company operates.
Downgrade or upgrade
This isn’t just a one-time process either: ratings are continually adjusted as those factors change, and a company can be upgraded 👍🏼 or downgraded 👎🏼. If there’s a downgrade, bond prices will fall because investors demand a greater yield from riskier investments.
Unfortunately for the affected companies, if a downgrade takes it into non-investment grade territory, funds that hold their bonds may be forced to sell as some funds have restrictions on what ratings they’re allowed to hold.
Don’t completely rely on rating agencies though. They’re often a lagging indicator, meaning that the price of a bond may have slipped a lot before the agencies catch up and change the rating. During the financial crisis of 2008, many of the debt securities backed by US mortgages that turned out to be nearly worthless had been given the top, AAA rating by agencies.
We know we bang on about this, but it’s always worth doing your own analysis of a company and its strategy before investing – as a general rule of thumb, if something seems really risky, you might want to think twice before investing, or simply avoid it.
As you know, when investing, your capital is at risk. This learning guide is for information purposes only and is not intended as investment advice.