Bond quality, S&P ratings and spreads investment guide

One of the things that determines the yield on bonds is uncertainty. Knowing the relationship between bond yields and uncertainty can help you get a yield that adequately rewards you for the investment risk you are taking.

A bond is essentially a loan - investors give money to an issuer for a set amount of time, and in return, they get a specified rate of interest. However, an important difference between a bond and an ordinary loan is that investors sell bonds to one another on a daily basis, and changing prices reflect changing conditions. Some of those conditions are general to the market as a whole, while some are specific to the bond's issuer.

Bond issuers are evaluated based on the degree of certainty that they will repay. This degree of certainty is referred to as "quality," and quality is an important determinant of bond yields.

Bond yields: What is a spread?

The global standard for high-quality debt instruments is the U.S. Treasury bond. Other bonds, whether issued by corporations, non-U.S. governments or municipalities are considered to have a higher risk of default. In return, investors demand a higher yield. The extra yield is measured relative to the yield on Treasury bonds and is called a "spread." For example, if 10-year Treasuries are yielding 3 percent and a certain corporate bond is yielding 5 percent, it is trading at a spread of 2 percent.

How high that spread is depends on two things:

1. The creditworthiness of the individual issuer

2. The overall level of optimism about financial conditions

Bond quality and ratings

The general principal is that the lower the quality of the bond, the higher the yield will be.

Quality is formally measured by ratings agencies such as Standard & Poors and Moody's, who use a range of quality ratings to assess the ability of issuers to repay. For corporate bonds, these systems usually are some variation of the type used by Standard & Poors.

The rating system by S&P is as follows:

Highest level of quality: AAA

AAA is the highest level of quality (considered just below Treasury bonds in quality). AA is the next highest, then A, BBB, BB, B and CCC.

Investment grade bonds: BBB and above

Bonds rated BBB or higher are considered "investment grade."

Junk bonds: BB and lower

Those rated BB or lower are considered "junk bonds." As a reflection of the fact that lower-quality bonds trade at higher yields, some people prefer to refer to junk bonds as "high-yield bonds."

Bonds in default: D

Bonds that are currently in default are giving a rating of D.

It should be noted that quality ratings are assessments of an issuer's current financial condition, and not a forecast of its future. Adverse events could cause a downgrade in quality rating, and market prices might anticipate that downgrade before it formally happens.

How bond rating changes can affect yield spreads

Getting downgraded or upgraded in quality rating is one way that yield spreads on a bond can change. Downgrades usually result in wider spreads, which mean lower prices, and the opposite is true of upgrades.

Besides changes in individual issues, the level of optimism in general about lower-quality bonds changes according to economic conditions, resulting in across-the-board changes for yield spreads. For example, due to the Great Recession, high-yield bond spreads went from about 2.5 percent in mid-2007 to over 20 percent by late 2008. This was a particularly extreme swing from high optimism to bleak pessimism. The 2001 recession saw a more moderate rise in spreads, from about 7.5 percent to just over 10 percent.

Low-quality bonds and price changes

A key to understanding the investment characteristics of lower-quality bonds is to remember the relationship between yields and price: when yields rise, prices fall, and vice versa. Because of how quality spreads can widen or narrow so drastically, lower-quality yields tend to be more changeable than higher-quality ones, meaning that lower quality bond prices are subject to more extreme price movements.

From a portfolio standpoint, this means that lower-quality bonds take on some of the characteristics of equities rather than playing the role of sure-and-steady high-quality bonds. Buy a low-quality bond whose outlook improves, and you should be rewarded with a strong price gain in addition to the higher yield that goes with a lower rating. However, if the outlook for a bond you hold worsens, you could be subject to a price decline which could become permanent.

Effectively then, investors need to understand that the lower the quality of a bond, the less it behaves with the certainty of bonds and more with the volatility of stocks. The higher yield being offered should be evaluated in the context of the higher level of risk.

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