In the previous article on bonds (“Part 1”) I gave an analogy to help readers understand how bond prices can move based on how the interest rate environment changes. Let’s go back to that bank lobby where we’ll pretend that you can buy and sell CDs to illustrate how other things can effect bond prices. Obviously you can’t buy and sell CDs and bonds are not FDIC insured like a CD is, but this is meant just to illustrate what could affect prices in a hypothetical environment. For now, we’ll take off the training wheels of the analogy and speak directly about bonds.
We covered how changes in the interest rate can affect the value (or price) of a bond. So can the credit risk of it. Let’s say that one year ago you bought a $100 5% three year bond from a company that was plugging along and now one year later there are rumors that this company could be going into bankruptcy. You need to get the money back and go to sell it. Obviously there aren’t a lot of investors who would want a bond only paying 5% on a company that may go bankrupt. So, in order to get your cash out of it you may have to drop the price of it very low to attract a buyer. We’ll just say $70. In which case, you made $5 in yield (interest) this year, but then lost $30 when you went to sell it (over all losing $25). On the other hand, let’s say you were on the other side of this and saw this bond for sale that pays 5% and is selling for $70. You believe the company will pull through their problems. You buy the bond and end up being right and the company survives. For the next two years you get your 5% yield ($5 each year) and then when it matures the company gives you the par value back ($100). In this case, on a $70 investment you got $40 back ($10 in yield and $30 in price) or what is about a 30% return each year.
This is an extreme example, but this illustrates where the credit ratings come into play (see my other article that explains the credit ratings on bonds). The three major credit rating agencies (Moody’s, S&P and Fitch) rate individual bonds. Usually in one year a company won’t go downhill as fast as the example above, but a company may see their ratings go down from “AA” to “A”. Or it may even have a change in its outlook from “stable” to “negative”. Conversely, their ratings can improve. There were many companies who came to the brink of collapse and have now pulled through. When investors buy bonds, from that day forward the credit outlook of those companies and their bonds will affect the price.
I think that these sorts of complications highlight the importance of professional bond management. A good bond manager can dig through these bonds and look for companies that have a stronger outlook than when the bonds were originally given a credit rating. A bond manager may find a bond that was rated as “A” when it was having some problems, but now feels that it should be rated “AA”.
Naturally, companies that are given a low credit rating generally will have to pay more yield to attract investors to their bonds. If a “BBB” rated company is offering a 4% yield, they wouldn’t be able to raise money if there is an “A” rated company offering the same 4% yield. A company desperately trying to avert bankruptcy may have to offer a 12% yield on their bonds to attract the capital. If they pull through and investors own 12% bonds on a company that has “returned from the brink” and is now rated “A” again, then the price of that bond should be very strong.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly