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Bonds · 06 / 09
Bond marketsLevel 2Intermediate8 minUpdated

Credit risk

Besides interest rates, the other big risk in a bond is credit risk: the risk that the borrower won't pay back. It is measured with ratings and priced through the spread.

What you'll learn
  • How credit ratings work and what the boundaries mean
  • What the credit spread is
  • Why the spread is the market's fear gauge

Credit ratings

Credit rating agencies assess the ability to repay on a scale. One boundary matters more than all the others: the one between investment grade and high yield.

AAA–BBBIG

Investment grade

Financially sound governments and companies; low credit risk, lower return.

BB AND BELOWHY

High yield

Weaker creditworthiness; higher coupon, clearly greater risk.

D—

Default

Insolvency; partial or total loss of capital.

The lower the rating, the higher the interest an investor demands as compensation. A rating is no guarantee. It is an assessment, and it can change during the life of the bond. In practice, investment grade means at least BBB− on the S&P and Fitch scale or Baa3 on the Moody's scale.

Chart
The five key risks of a bond ETF
These are worth understanding before you buy.

Interest rate risk

When market interest rates rise, the ETF's value falls.
A large effect on long bonds, a small one on short bonds.
Key risk

Credit risk

The issuer's insolvency can cause losses.
Greater in high-risk bonds than in AAA bonds.
Depends on the rating

Liquidity risk

Market conditions can make it hard to sell at short notice.
Trading can temporarily deteriorate in times of crisis.
Temporary

Currency risk

If the ETF doesn't hedge the currency, you are exposed to exchange rates.
Exchange rates can boost or weaken the return.
Can be hedged

Inflation risk

The nominal return can fall short of inflation and cause a real loss.
Interest rates below inflation reduce purchasing power.
Important

The first two are the most important. Interest rate risk and credit risk are not the same thing: in a government bond credit risk is low but interest rate risk can be high, while in high yield it is often the other way round.

The credit spread

The credit spread is the extra interest a corporate bond pays on top of a comparable government bond: compensation for credit risk.

Chart · illustrative example
What a corporate bond's yield is made of
The same 5-year maturity, three different issuers.
Government bond3.0%
Risk-free 3.0%
Corporate bond · IG4.1%
3.0%+1.1
Corporate bond · high yield7.0%
3.0%Spread +4.0
Risk-free rate IG spread HY spread

The base is the same risk-free rate for all of them. The difference comes entirely from the spread: how much compensation the market demands for the uncertainty of repayment.

The spread is the market's fear gauge

When the economy is doing well and confidence is high, spreads are tight: little is paid for risk. As a crisis approaches, spreads widen quickly, which lowers the price of corporate bonds already in circulation.

Tight spread
The market is complacent.
Little is paid for risk. The extra yield of a corporate bond over a government bond is thin. Is the risk worth taking then?
Wide spread
The market is afraid.
A lot is paid for risk. The prices of existing bonds have fallen, but a new buyer gets better compensation.

As a bond investor, it is worth keeping an eye on whether risk is being paid for well enough right now. The same bond can be a good or a bad investment depending on the spread at the time of purchase.

What kind of companies issue high yield bonds?

  • Young, fast-growing companies that don't yet have a long financial history.
  • Companies that have taken on a lot of debt, for example to finance an acquisition.
  • Companies in cyclical industries whose cash flow varies a lot.

Under market stress, high yield can behave more like stocks than like strong government bonds. That is why it shouldn't be thought of as the portfolio's safe haven. It is a bond investment that adds return potential and carries clearly higher credit risk.

This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns.

Check your understanding
Test yourself: credit risk
Three questions. Pick an answer to see the explanation right away.
Kysymys 1 / 3
What is the credit spread?
Kysymys 2 / 3
What happens to corporate bond prices when spreads widen?
Kysymys 3 / 3
Which boundary separates investment grade from high yield?
Score: 0 / 3

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