What You Must Know About Interest Rates and Credit Risk
Corporate bonds are highly touted for their high yield in comparison to other bonds, and their stability in comparison to the stock market.
However, uninformed investors may not be aware that, while safer than many other options, there are still concerns with corporate bonds.
Because these bonds are not secured by collateral, there’s the risk of both interest rate fluctuations and credit risk.
By knowing how to assess interest rate and credit risk, you are able to make informed decisions with their wealth.
Understanding Bond Yield
“Yield” refers to the total earnings from all coupon payments, as well as from price appreciation of the bond.
Current yield is just the part of the return created by coupon payments. Generally, you’ll see those twice a year, and it makes up the bulk of what you’ll earn with a corporate bond.
Let’s say that you buy a corporate bond for $95. It has a $6 coupon. The current yield for this bond is about 6.32%, which you can find by dividing the coupon by the cost of the bond’s purchase.
Any price appreciation that adds to the total yield of a bond is due to buying the bond at a lower price than its actual cost (at a discount), and then holding it until the bond fully matures. This allows you to receive the par value of the bond.
You’ll find that some bonds have no coupon (called a zero-coupon bond) and that the entirety of the yield is based on price appreciation instead of coupon payments.
If you’re looking for a reliable return and aren’t particularly worried about “big wins”, then corporate bonds are always better options than Treasury bonds.
With annual coupons, you can enjoy a highly-predictable return, often significantly higher than what you’ll earn from the stock market, and without most of the accompanying risks.
Understanding Credit Risk
As mentioned, credit risk can reduce your return with corporate bonds. Standard and Poor, Moody and Fitch all publish credit information that is designed to help you make informed decisions, but this information is often supplemented by in-house analysis from institutional investors.
While there are many potential tools to use in assessing credit risk, interest-coverage ratios and capitalization ratios are two of the most frequently used options.
Basically, an interest coverage ratio is designed to tell you how much money the company issuing the bond generates each year to fund its debt. The higher the ratio, the better. Essentially, this tells you that the company is generating more than enough income to cover its debts.
A capitalization ratio tells you how much interest-bearing debt the company carries in relation to the value of its assets. It’s pretty similar to assessing the amount owed on a home mortgage in relation to the value of the home. If the amount owed exceeds the value of the home, then you’re underwater. The same is true for businesses with more debt than assets.
Look for a lower ratio here (under 1.0), as this means that the company has excellent financial leverage.
When you buy corporate bonds, you’re essentially assuming credit risk in return for extra yield. However, you’ll need to ensure that the extra yield is worth the risk of default on the part of the company.
The higher the credit risk of the company, the less appealing the bond should be – you need to hedge your bets and buy corporate bonds from companies with low credit risk.
Beyond Credit Risk: Credit Spread
The wider the difference in the spread, the more risk is present, but also the higher the potential yield with corporate bonds.
Credit spread can change over the life of a bond.
For instance, if the issuing company’s credit rating is upgraded, meaning that it is performing better and risk is lower, then the spread will reduce, as will your potential return unless interest rates change as well.
It’s important to avoid bonds with very narrow spreads, but equally important that you avoid those with very wide spreads, as they carry significantly greater risks.
It’s all about understanding credit risk, credit spread, and how to make a smart, informed decision with your wealth. By understanding these risks and how corporate bonds work, you can grow your wealth while hedging against market fluctuations.
Investing in investment grade corporate bonds, and holding them until maturity, will help to eliminate the risks of interest rate increases and the widening of credit spreads.
Diversification will help to diminish the risks of issuer defaults, as well.