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| Default Risk |
What It Is:
Default risk is the chance the a bond issuer will not make the required coupon
payments or principal repayment to bondholders.
How It Works/Example:
Although the definition of default risk may be fairly concrete, measurement of
it is not. Many things can influence an issuer's default risk and in
varying degrees. Examples include poor or falling cash flow from operations
(which is often needed to make the interest and principal payments), rising
interest rates (if the bonds are floating-rate notes, rising interest rates
increase the required interest payments), or changes in the nature of the
marketplace that would adversely affect the issuer (such as a change in
technology, an increase in competitors, or regulatory changes). The default risk
associated with foreign bonds also includes the home country's sociopolitical
situation and the stability and regulatory activity of its government.
S&P's ratings vary from AAA (the most secure) to D, which means the issuer is already in default. Moody's ratings go from Aaa to C. Only bonds rated BBB or better are considered "investment grade." Anything below BBB- or Baa3 is considered "junk," or "below investment-grade."
| Moody's | S&P |
Meaning |
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Investment Grade Bonds |
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| Aaa | AAA | Bonds of the highest quality that offer the lowest degree of investment risk. Issuers are considered to be extremely stable and dependable. |
| Aa1, Aa2, Aa3 | AA+, AA, AA- | Bonds are of high quality by all standards, but carry a slightly greater degree of long-term investment risk. |
| A1, A2, A3 | A+, A, A- | Bonds with many positive investment qualities. |
| Baa1, Baa2, Baa3 | BBB+, BBB, BBB- | Bonds of medium grade quality. Security currently appears sufficient, but may be unreliable over the long term |
| Non Investment Grade Bonds (Junk Bonds) | ||
| Ba1, Ba2, Ba3 | BB+, BB, BB- | Bonds with speculative fundamentals. The security of future payments is only moderate. |
| B1, B2, B3 | B+, B, B- | Bonds that are not considered to be attractive investments. Little assurance of long term payments. |
| Caa1, Caa2, Caa3 | CCC+, CCC, CCC- | Bonds of poor quality. Issuers may be in default or are at risk of being in default. |
| Ca | CC | Bonds of highly speculative features. Often in default. |
| C | C | Lowest rated class of bonds. |
| - | D | In default. |
Why It Matters:
Default risk is perhaps one of the most fundamental types of risk. After all, it
represents the chance the investor will lose his or her investment. All bonds,
except for those issued by the U.S. government, carry some level of default
risk. This is one reason corporate bonds almost always have higher coupons than
government bonds.
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