Notes on Bond Investing and Credit Risk

Introduction to Credit Risk

• Credit risk: The chance that a bond issuer will default on its obligations to investors.
• Importance of assessing credit risk through research on the issuing entity and its credit rating.

Credit Rating Agencies

• Three primary agencies that evaluate bond issuers:
  • Standard & Poor's Rating Services (S&P)
  • Moody's Investors Services
  • Fitch Ratings
• These agencies publish bond ratings based on various factors affecting issuer stability.

Factors Evaluated in Credit Ratings

1. Nature of the Issuer's Debt
2. Reliability of Cash Flow
3. Ability to Make Interest Payments
4. Ability to Return Principal
5. Overall Management of the Entity
6. Stability of the Industry or Municipality

Bond Ratings

• Bond ratings can change based on the quality of the evaluated features.
• Inverse relationship between bond ratings and yield:
  • Higher-rated (investment-grade) bonds pay lower yields.
  • Lower-rated (junk bonds) pay higher yields as compensation for increased risk.

Rating Scales of Agencies

• S&P Rating Scale: Uses capital letters with plus and minus indicators for quality.
• Moody's Rating Scale: Uses a combination of upper and lowercase letters, numbered one to three.
• Fitch Rating Scale: Similar to S&P's system.

Investment Grade Bonds

• Defined as bonds rated BBB or BAA and higher.
• Also known as bank grade bonds, approved by the FDIC for bank purchases.
• Preferred by conservative investors due to lower risk.

Conclusion

• Understanding credit risk and bond ratings is crucial for investors.
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