Most financial planning groups we work with approve their advisers to use Investment Grade corporate bonds. What does this actually mean?
The major international credit rating agencies S&P, Moodys & Fitch analyse the credit quality of a company and develop a rating based on predicting the company’s ability to repay its debts. Ratings of BBB- or better are considered to be Investment Grade. Below this is called sub-investment grade or speculative grade bonds. Ratings are constantly monitored and can change over the life of a bond.
The importance of an Investment Grade rating
An Investment Grade rating is highly important for a company. Not only is it a vote of confidence in the future performance of the business, but it dramatically affects the rate at which they can borrow from banks or bond investors. In general, if a bond falls below Investment Grade, the price of the bond should fall. In some cases the company will have to pay a higher rate of interest (coupon) to its bond holders.
Investment Grade ratings can also affect who a company can sell their bonds to. Many bond fund managers are not able to hold sub-investment grade securities, which limits the potential clients. Companies with sub-investment grade bonds may end up having to pay a higher coupon rate for their bond issue. This is a similar concept to equity fund managers not being able to hold securities outside the ASX200. The main hurdle to inclusion in the ASX200 is business size, determining a credit rating however, is a much more in-depth process.
Determining a credit rating
When determining a company’s rating, the credit rating agency takes into account a myriad of factors to come up with a well-balanced view of credit risk. Leverage, cash flows, earnings, interest coverage ratio and other financial ratios are common indicators that the credit rating agency considers when assigning an investment grade to a specific security.
When building a portfolio of bonds, comparing one bond to another is a fairly simple process thanks to credit ratings. Two bonds with the same rating, term and yield could be priced very close to each other, no matter the industry they operate in. This is very different to equities, where one research house will love a stock and and another will recommend selling it.
How do ratings relate to risk?
The major risk of investing in bonds is the issuing company not repaying the principal or missing a coupon payment, this is known as a credit default. A credit default would have major ramifications for bond holders but also equity holders of a company, the share price would obviously fall if the company cannot meet its debt payments.
How often do bonds default is the key question and that is where the credit ratings become very important. The below table shows the global default rates from companies from 1981 – 2016. The default rate for 3-year Investment Grade bonds is 0.46%, currently all XTBs are over Investment Grade bonds, although the terms may be longer than 3-years. Defaults in speculative grade bonds jump to 10.63% for the same term globally.
Investment Grade defaults in Australia have been very rare. In fact there have only been two in the past 30 years – Babcock & Brown and Pasminco. From these numbers it is clear why many financial planning groups are happy for advisers to hold any Investment Grade bond, as the default risks are very low. Many advisers also look to include a spread of companies and bond terms to further reduce the risk of the portfolio.
When holding a bond, the risk of a credit default is substantially mitigated if you stick with Investment Grade bonds.