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Bond types and credit quality

This animated tutorial explains the different types of bonds and how credit ratings work.

 

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Till now, we’ve been talking of bonds in very generic terms. In reality, bonds come in a number of flavours, from a variety of issuers.

Let’s have a look at some of these, from corporate bonds to government bonds and from investment grade to junk bonds.

Governments all over the world issue bonds to finance their spending.

Government bonds come in a variety of different types with both short and long terms to maturity.

Many investors consider UK government bonds, or ‘gilts’, as the standard bond investment since they are backed by the full weight of the British government. They own the printing presses after all!

Governments, and increasingly some companies, also issue a type of bond that links its coupon payments to inflation rates, rather than keeping them fixed.

These types of bonds generally offer a given percentage rate above inflation, often one per cent. So, for example, if the inflation rate is two point five per cent in a given period, the bond will pay three point five per cent for that period.

These bonds appeal to investors who want to protect their capital from inflation, which erodes the purchasing power of their investment.

Companies in the UK and abroad can also issue bonds, just like governments.

Companies issues bonds to finance their start up, growth plans or short-term operations.

Investors can then trade these bonds among themselves in the open market, just like government bonds.

Just like lending money to your friends, you’ll need to think about the chances of getting your money back when you lend to a company by buying its bonds.

Some companies are more financially sound than others. This has a knock on effect on the coupon a company has to pay to attract buyers.

Corporate bonds are issued from every type of company. This includes large, profitable multi-national companies, all the way down to start-up companies or distressed businesses that are not making any profits and with little credit history.

Companies that have a good reputation can issue bonds at a much lower coupon rate and still find a buyer. A start-up company, for example, might have to promise a much higher coupon in order to tempt investors into buying their bonds.

Remember that bond investors are lending money to the bond issuer. It’s a loan in other words. So the credit worthiness of bond issuers is something that every bond investor thinks about.

So, how do we make sense of it all?

Because bond investors are, in effect, lending money to bond issuers, it makes sense that bond issuers would have a credit rating, just like you do when you go to get a mortgage.

Several credit agencies fulfil the role of assigning credit ratings to bond issuers and the bonds that they issue.

These ratings read a bit like an alphabet soup of letters.

All these different letter designations serve to rate bond issuers from the highest to the lowest. The highest rating – most agencies use triple “A” – denotes the prime lenders, such as stable governments with strong economies, or large multi nationals.

The lowest ratings, say, “C” or “D” are distressed companies that might go bust or have trouble paying their coupon payments.

But remember, no credit rating is fool proof!

During the global financial crisis, a ‘triple A’ credit rating did not protect investors who invested in certain types of bonds.

As a result, some people have questioned the role and effectiveness of these agencies and most market participants would agree that ratings aren’t perfect.

However, they’re one of the few ways of assessing and comparing the riskiness of bonds and bond issuers.

The imperfect nature of credit ratings strongly supports the practice of broad diversification, both within UK bonds and perhaps globally as well.

Remember, you can’t control what happens to an individual bond issuer, but you can help to offset some of the individual bond risk by holding a broad mix of bonds and bond types.

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Other important information:

This video was produced by Vanguard Asset Management, Ltd. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

If this is to be used on third party websites for an audience of professional investors as the submission suggests I would also include the for professional investors disclaimer at the top.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2018 Vanguard Asset Management, Limited. All rights reserved.