Understanding Default Risk in Bond Investing
Default risk in bond investing refers to the chance that a bond-issuing company or government would fail to make its debt and interest payments. As a bond investor, you can lose 100% of your investment along with uncollected interest. But there are several steps you can take to hedge against default risk. You can also seek the guidance of a financial advisor who can help you make the right investment decisions.
What Triggers Default Risk?
Several factors can push a company to default on its bond payments. From internal dysfunction to a fragile economy, plenty of events can cripple a company, causing its inability to make its bond payments. Even a government can collapse and go into default on the bonds it issues. But you can cut through the uncertainty by examining companies and governments before you invest in their bonds.
Pay close attention to the company’s financials. In most cases, you can find quarterly reports on its website. If it looks like the company’s in trouble (e.g., its cash flow drastically declined compared to previous quarters), it may be at greater risk of defaulting.
Another key factor to consider is the bond’s rating.
Bond Ratings
Several firms grade bonds based on how likely the entities that issue them are to default. The most well-known rating agencies are Standard & Poor’s (S&P), Fitch and Moody’s, though there are actually 10 the SEC has designated as Nationally Recognized Statistical Rating Organizations (NRSROs).
The scores that rating agencies provide for bonds can be pooled into two categories: investment grade and non-investment grade or junk. The ones least likely to default earn investment grade. As the name implies, junk bonds are the lowest-rated debt securities.
Junk bonds are also called high-yield bonds. That’s because, as with many investments, they pay a higher interest rate in exchange for the greater risk. In other words, the lower the rating or creditworthiness of a bond issuer, the higher the yield it offers. If you consult a financial expert to help guide you through making the right choices, make sure you know what questions to ask a financial advisor before you have your initial meeting.
Rating agencies have different systems for rating bonds. For example, the S&P’s investment grade ratings are AAA, AA, A and BBB. Anything below is considered non-investment grade. Those rated D are already in default. But keep in mind that market swings, changes in the company’s structure and profits and other factors can significantly alter a bond’s rating.
So you should keep an eye out for rating changes, particularly downgrades, of the bonds you hold.
Mitigating Bond Default Risk
In addition to the ratings, investors can measure a bond’s risk of default by using the interest coverage ratio. You can calculate this by dividing a company’s earnings before interest and taxes (EBIT) by its periodic debt interest payments. Companies with higher interest ratios may be less likely to default.
As mentioned earlier, another indicator of bond default risk can be its cash flow. You can measure a company’s cash flow by subtracting capital expenditures from its operating cash flow. You can typically find these figures in a company’s financial statements on its website.
A company turns to its cash flow to make its debt and dividend payments. One with cash flow edging to zero and dipping into the negative may suggest it’s having trouble fulfilling these obligations. On the other hand, one with large cash flow could indicate less risk of default.
Risk in Bond Investing
Bonds are generally considered safer investments than stocks and other securities. But this doesn’t mean they come without risk. As you can see, some companies or bond issuers are better bets than others. The causes for default can vary from changes in the interest-rate environment to adverse effects in the firm’s industry such as changing technologies and the presence of stronger competitors.
And just as companies can fail, so too can entire governments that fund operations by issuing bonds. However, analysts consider U.S.-issued bonds among the safest in the world. That’s why corporate bonds usually always carry higher coupon (or interest) rates. Yet bonds from other countries may have even higher yields. After all, not all governments are as strong as that of the U.S. So when investing in bonds of foreign governments, you may want to pay attention to how changes in that nation and others may adversely affect its ability to pay back its debts.
The Takeaway
Though generally safer than equities, bond investing comes with a certain degree of risk. You can hedge the risk by choosing only investment-grade or U.S. government bonds. But you’ll get less return. For a bigger yield, you’ll need to take on more risk, which can be tempting in a prolonged low-interest environment. Tread carefully, though, when chasing yield. If you’re new to bonds, you may be best off consulting a financial advisor.
Tips on Investing in Bonds
Bonds are good for diversifying a portfolio. But to maximize return, you need to have the right mix. You can use our asset-allocation calculator to see what a suitable investment mix may look like based on your risk tolerance.
Now you know about investment-grade, high-yield and U.S.-issued bonds. But you’ve hardly scratched the surface. If you’re interested in exploring more, check out our guide on other types of bonds.
If you’d like professional investing guidance, we can help you find some. Use our SmartAsset financial advisor matching tool. It links you with up to three financial advisors in your area. You can review their qualifications before deciding to work with one.
Photo credit: ©iStock.com/ipopba, ©iStock.com/SamuelBrownNG, ©iStock.com/23d7d4d_101
The post Understanding Default Risk in Bond Investing appeared first on SmartAsset Blog.
