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| Although fixed income investments are subject to a variety of risks (See Risks of Fixed Income Investing), most of these are based on the broader market and rate environment. Credit risk is specific to the issuer and its industry and is something investors should pay close attention to in making a fixed income investment. Credit risk is the risk that the issuer will default or be unable to make further principal or interest payments. |
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| Credit risk events, like default and downgrades, occur more often in corporate and municipal bonds than any other fixed income product type. Credit ratings assigned to bonds will vary depending on the financial strength of the issuer. |
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| Most investors realize that bonds with a lower credit rating carry more risk. In addition, it is a fact of fixed income investing that bonds with a higher yield may also carry more risk. So how can an investor use this information to evaluate a potential fixed income investment? |
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| The bond's credit rating is the first indication of the bond's quality. Third-party ratings such as Standard and Poor's (S&P) and Moody's assign ratings to bonds, which reflect their evaluation of the creditworthiness of an issuer. Investment grade bonds are less likely to have their ratings downgraded or to default than non-investment grade bonds. While investment grade bonds may also be downgraded or default, a bond with a higher rating is less likely to experience a downgrade or default. (See Bond Ratings.) |
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| The table below shows the historical likelihood of rating changes or default, by rating, on corporate bonds as ranked by Moody's. The table shows that on average only 23.3% of all bonds rated AAA were downgraded to AA over a 5-year horizon. In addition, 1.6% of Baa bonds defaulted within 5 years, compared to only .1% of AAA bonds. Keep in mind that these are average default and downgrade rates, and that during periods of economic weakness, defaults and downgrades may be higher (see chart below). |
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| Bond ratings should not be the only way an investor evaluates a bond. News on an issuer may be known to the market before a rating agency has issued an updated rating or put the issuer on credit watch. As a result, a bond's rating may not reflect current information. Carefully research the industry, municipality and issuer to determine if there has been any recent news which may affect the bond or its issuer in a negative manner. |
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| Higher coupon rates and yields are generally found on bonds with lower ratings and/or greater time to maturity. (See How Bonds Work.) |
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Bonds with lower ratings tend to have a higher risk of default or having their credit rating downgraded. |
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Even among investment grade bonds, the risk of default or downgrade increases as the duration/maturity of the bond increases. |
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| In addition, you can review the bond's yield compared to similar bonds. If the yield is significantly higher than that of the similar bonds then that may indicate an investment risk is built into the price and yield of the bond. When comparing bonds they must be similar in credit quality, maturity, structure and industry. |
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| The default rate of corporate bonds may also be affected by the strength of the economy. As the chart below shows, economic conditions can greatly affect the likelihood that a company will be unable to meet its bond obligations. |
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U.S. Treasury securities are AAA and are considered to be virtually free of credit risk as they are backed by the full faith and taxing power of the United States. |
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U.S. Agencies also carry a AAA rating but will generally have a slightly higher yield than treasuries because they have the "implied," but not actual, taxing power of the United States government. |
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Bond Funds, due to the number and type of bonds in their portfolio, offer diversification, which can help minimize credit risk. |
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