Key Takeaways
- Global bonds offer investors a reliable way to earn steady income while diversifying beyond the stock market.
- Understanding credit ratings and issuer stability helps assess risk and choose quality bond investments.
- Bond ratings are essential tools that help investors evaluate the level of risk and security tied to various bonds.
- Bond performance depends on more than credit ratings; managing interest rate, inflation, liquidity, and issuer risks builds a stronger, more resilient portfolio.
The Basics of Global Bonds: Risk, Ratings, and Returns
Global bonds are a popular choice of investment for local investors seeking fixed income options and are a good alternative to the stock market. These bonds are primarily issued by governments and corporations as a means of borrowing funds for the short (max 1 year) to the long term depending on their needs.
They will specify a rate of interest which is normally payable quarterly, half-yearly or annually along with a maturity date. The rate of interest payable (coupon rate) is dependent on the corporation’s credit risk i.e. the probability of their defaulting on the loan.
Credit rating agencies like Standard & Poor’s, Moody’s, and Fitch assess this risk by analyzing a company’s financial strength and stability. Those with solid fundamentals and a strong future outlook receive higher ratings, reflecting a lower chance of default.
For a breakdown of rating agencies, explore Rating Agencies and Bond Markets.
Higher Risk, Higher Reward
Naturally the old maxim of higher risk, higher reward then comes into play as those corporations with a good credit rating are more likely to attract investors to purchase their bonds as their probability of default in repayment of the debt will be significantly lower than lower-rated corporations.
This rating will enable them to raise funds at a lower cost than corporations that have a low credit rating. The latter corporations will have to offer higher rates in order to attract investors to take on that risk because of the higher probability of default.
High Yield vs Investment Grade Bonds
The bond credit rating given by rating agencies is what is used to determine whether a bond is investment grade or high yield/junk bond. Investment grade bonds are less risky with lower returns, while high yield bonds, rated below ‘BBB-‘, are riskier with higher returns.
Investment grade bonds are usually favored when economic conditions are deteriorating. However, under buoyant conditions, demand for high yield bonds increases. Higher yielding bonds have generally outperformed lower yielding ones.
Bond Rating Grades
Bond ratings play a crucial role in helping investors assess the level of risk associated with different bonds. Investment grade bonds are considered safer, offering lower yields but greater stability. On the Standard & Poor’s (S&P) scale, investment grade ratings range from a high of AAA to a low of BBB-. On Moody’s scale, this corresponds to ratings that range from minimal credit risk to moderate credit risk.
In contrast, high-yield or “junk” bonds carry higher risk and therefore higher potential returns. These bonds fall between BB+ and D on the S&P scale, reflecting credit quality that ranges from substantial risk to in default, with little chance of recovery.
It is important for investors to take the time to understand these fundamentals if they are considering investing in bonds and if they are unsure, then they should take the time to ask their investment manager to explain it to them.
Balancing Risk and Reward in Your Bond Portfolio
Finding the right mix of safety and return starts with understanding your own risk comfort and investment goals. Make sure you note:
- Every investor has a different risk appetite based on their financial goals and comfort level.
- A bond classified as “junk” does not necessarily mean the issuing corporation will default.
- High-yield bonds offer greater returns but come with increased risk.
- Investors seeking higher income potential may consider including some high-yield bonds in their portfolio.
- It’s important to carefully assess how much of your portfolio can be allocated to higher-risk bonds, enough to boost returns, but not enough to cause sleepless nights.
Risk Factors Beyond Credit Ratings
Credit ratings assess default risk, but other factors can also impact a bond’s performance.
Interest Rate Risk: Rising rates can lower the market value of existing bonds.
Inflation Risk: Higher inflation reduces the real return on fixed interest payments.
Liquidity Risk: Some bonds are harder to sell quickly without losing value.
Issuer Event Risk: Corporate actions like mergers or restructuring can affect repayment ability.
Understanding these factors helps investors build balanced, resilient bond portfolios.
FAQs
What is The Downside of High-Yield Bonds?
The main downsides of high-yield bonds are a higher risk of default, greater volatility, and lower liquidity.
Why do high-yield bonds offer higher returns?
They carry more credit risk. To attract investors, issuers must offer higher interest rates, resulting in potentially higher yields.
Are High-Yield Bonds Always Risky?
They involve more risk than investment-grade bonds, but not all are unsafe. Some lower-rated companies still meet obligations reliably, making selective investing important.
Which Type of Bond is Right For Me?
That depends on your risk tolerance and investment goals. Conservative investors may prefer investment-grade bonds for stability, while those seeking higher returns may allocate a portion to high-yield bonds for added income potential.
From The Sterling Team
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