Credit Risk — Keeping score with credit ratings
Rate your borrower
A similar credit rating theory applies to investing, typically with fixed income or debt investments like bonds. When you buy a bond or a bond fund, you are loaning money to the bond issuer. In return for this loan, the bond issuer agrees to pay back your principal at a future date and also to pay interest. So it makes sense that you’ll want to know how likely it is that the issuer of the bond (usually a corporation or a government agency) will be able to repay your principal and pay the interest as promised.
One of the best ways to manage credit risk is by choosing different types of investments.
Bonds issued by the federal government are considered to have very low credit risk because the government can typically print more money to make its interest and principal payments. But bonds issued by corporations can have varying levels of credit risk, because corporations can go bankrupt and default on their bond payments. Just as you would pay a higher interest rate on your car loan if you had a poor credit score, corporations with low credit ratings must pay higher interest on their bonds to make up for the increased credit risk to investors. In between the feds and corporations are local and state governments (if you were to put these issuers on a risk spectrum). Generally, state and local government bond issuers have good ratings. And when their (State and local government) ratings are high, their credit risk is low.
Get all the scores
Investors can find credit risk ratings from three agencies—S&P, Moody’s and Fitch. Each agency has its own scorecard. Here’s how S&P rates the top four risk levels—what’s referred to as investment grade bonds (there are numerous other ratings for lower quality bonds):
- AAA — Best credit quality; extremely strong ability to meet financial commitments.
- AA — Very strong ability to meet financial commitments.
- A — Still good but could be affected by economic conditions.
- BBB — Adequate ability to meet financial commitments.
Balance risk and return
Like other forms of risk, one of the best ways to manage credit risk is through diversification - selecting multiple types of bonds and bond funds. However, while diversification is a powerful investment strategy, it cannot guarantee market gains or protect against market losses. You can help keep your overall risk down by investing a portion of your savings in investments with lower risks, while investing another portion of your portfolio in higher risk investments. Keep your eye on the ratings and you’ll always know the score.