Friday, July 3, 2009

The importance of the bond issuer?

In one of my previous post i introduced the bond. You would remember that a bond is a security which is similar to an IOU. You are the lender and the entity is the borrower.

However, not all bonds are equal and some are more risky than others. Please read this post on risk and risk tolerance to familiarise yourself with the concept. Because bonds may sometime be long term investments, you need to be sure that the issuer will be solvent and has not gone bankrupt before you can get back your principal.

We are going to see below the different type of bond issuers and see which one is risky and which one is safe. But remember that the riskier the bond the greater the return. So if you are lucky and the bond issuer has not defaulted on you, it would mean that you are going to get a lot of interest or coupon payment along the way and your principal at the end.

Bond rating

Each bond has a rating associated that is provided by rating agencies. These agencies analyse the government and the company and give a rating which is simply their ability to remain solvent until the bond reach maturity. Hence a company/government with a good rating has a small chance of going into default while a poor rating means that the company/government has a good chance of going into default. The following table are the ratings that two main rating agencies associate with bonds and examples of companies.

Bond Rating Grade Risk
Moody's S&P/ Fitch
Aaa AAA Investment Highest Quality
Aa AA Investment High Quality
A A Investment Strong
Baa BBB Investment Medium Grade
Ba, B BB, B Junk Speculative
Caa/Ca/C CCC/CC/C Junk Highly Speculative
C D Junk In Default

Investment grade - Major developing countries, multinational, profit making companies,etc
Junk - Loss making companies, third world countries, etc

Generally as the bond moves from the highest investment grade to the bond grade rating, the interest rate increases. This is because the company/government issuing the bond has a greater chance of going into default and as a result you must be compensated for the risk that you are taking.

1. Government Bonds

These bonds are issued by government to finance budget deficit. This takes place when government has less tax than the money they want to spend. Generally governments obtain money by raising taxes and as a result the possibility that a government will default on its bonds is low. However with countries like Zimbabwe the possibility of default is quite high. However for most developed countries bonds are quite safe. As a result of this the interest rate on government bonds is quite low with practically no risk premium.

Even though the yield is low, it is generally advised to invest at least 10 % of your money in government bonds to minimise the risk of losing all your money in a stock market crash.

2. Municipal bonds

These bonds are the second safest behind government bonds because towns and cities can also raise taxes. However they have a lesser number of tax payers and as a result the have a higher chance of going into default. It may happen on the long run that the population of a town decreases and make the servicing of its bonds difficult. A more recent example is the towns in Michigan that are having lower population because of the demise of the car industry. Hence because the bond is a little bit more risky, the yield on it is higher. It is therefore advisable to have some municipal bonds in your portfolio. May be in the form of muni index fund.

3.Corporate bonds

The corporate bond is the most risky of all bond. The bond is the second way that a company can raise fund. One is to issue stock and the other is to issue bonds. You can read about the difference between bonds and stocks here. The reason why corporate bonds are the riskiest is because companies goes bankrupt every year. They cannot raise taxes like municipalities or governments.
As a result corporate bonds offer the highest yield. However in order to minimise risk, you need to diversify your corporate bond portfolio. Read here on diversification. Better still, if you are unable to diversify a bond portfolio by yourself invest in a corporate bond index fund.

Do you have any question on bonds or want to share your experience? Leave a comment below.

What is a bond?
Stocks have higher return than bonds
Introduction to diversification
What is a bond ladder?

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