Credit quality

In the investment world, the terms credit, credit risk and credit quality are repeatedly used when speaking about different asset classes, investment types and issuers of debt. But what do these terms mean and how should they factor into our investment making decisions?

In its broadest definition, credit is an agreement between a lender and a borrower. The borrower promises to repay the loan at a later date and usually with interest. The specific terms of the loan are predetermined and set out in the agreement. This agreement is exactly what a bond is. The issuer of the bond (the borrower) agrees to borrow from the investor (the lender) for a specified period and at a specified interest rate. Any other terms and conditions are determined before the transaction is executed.

As the lender, the investor takes on the risk of the bond issuer not being able to repay the principal &/or interest. This is known as credit risk. Investors should ensure that the agreed interest rate on the bond adequately compensates for the risk which they are accepting. Consequently, interest rates will vary across different issuers based the issuer’s ability to repay. Determining the issuer’s ability to repay is not a simple task, especially when comparing multiple issuers to ascertain the best investment to make.

Across all asset classes, there is a wide spectrum of risk levels. For example, in the bond market the range of risk levels go from low to medium to high risk with many points along the continuum. To make comparing investments easier, rating scales have been developed to allow the investor to assess the credit quality of an issuer. Having these scales, with the ratings assigned to issuers, allows for quick and easy comparison. It allows the investor to determine if they are accepting the best risk adjusted return available in the market. The risk adjusted return simply means receiving the best interest rate commensurate with the individual investor’s risk appetite. The rating scales and rating assignment to issuers are prepared by large international corporations who conduct continual research on issuers and make changes to issuer ratings as the data prescribes.

When making investment decisions, interest rates are not the only factor one should consider. It is important to compare the levels of risk as well as the interest to be earned. Only looking at the rate of return and ignoring the inherent risk, could cause the investor to take on more risk than they are comfortable with, or forego making an investment which matches their appetite and has a higher-than-normal return. Both factors of risk and return must be considered in making investment decisions. Compare apples with apples and not apples with oranges.

Always remember that when making investment decisions, it is best to speak with a licensed investment advisor. They can provide the information needed to make the best decisions. When buying bonds, ask about the ratings, understand the credit quality, and make the best, most informed decisions.

Dwayne Neil, MBA, is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: if you wish to have Sterling address your investment questions in upcoming articles, e-mail us at info@sterlingasset.net.jm.