Credit risk in bond investments

At its most theoretical, bonds do not appear to have any associated dangers. In fact, the bond market is seen as one of the safest markets in which to invest. However, in practice (and in reality) things change. “One of the most widespread misconceptions is that investing in fixed income is risk-free. Any investment product contains risk to a greater or lesser extent,” warns the National Securities Market Commission (CNMV), the regulator that oversees market security in Spain.

In this case, investors face a number of risks when investing in bonds: market risk, liquidity risk and credit risk. Although all of them are important, and should be taken into account, special attention should be paid to the last one, as its effects can be fatal to our savings.

What is credit risk?

The credit risk is the one “that is assumed by the possible lack of collection of interest and/or principal of the investment by the issuer,” explains the CNMV itself. As you can see, this is a vital danger for our investment, since it puts at risk the totality of the capital (savings) invested in it, so it is of great importance when investing in the bond market.

Rating agencies

Since credit risk is so significant, the market and investors obviously pay great attention to it and try to keep it under control at all times. For this purpose, there are agencies called rating agencies, which are in charge of classifying issuers according to this type of risk.

The best known are S&P, Moody’s, Fitch or DBRS, and they are in charge of analyzing the credit quality and financial strength of the issuers and each of the issues, based on their capacity to generate profits in the future and, consequently, to be able to meet their payments. Finally, they classify each issuer within a scale ranging from maximum security, investment grade (AAA), to a high probability of default, speculative grade or junk bond (rating C or lower).

Credit risk and profitability

Credit risk is of great importance when investing in bonds, mainly because it is the pillar on which the profitability offered by each security pivots. Thus, as it is logical, those issuers that are solvent and have a high rating from the rating agencies pay a lower return on their debt than those with a lower rating. After all, investors will demand a higher payout because they are taking more risk.

So, when creating a fixed income investment portfolio, the most important thing, as always, is to set a goal and match a return to that goal. Once we have both variables we can configure the investment portfolio giving more preponderance to those bonds that are safer and less profitable or to those with a little more risk, but also more profitability.

Factors that determine credit risk

In order to better understand credit risk, it is necessary to explain the factors that determine it, so that the concept can be better understood:

• Solvency and payment history of the issuer: the first point, as we have seen, lies in knowing in detail the issuer of the debt. In this case, the most important thing is to pay attention both to the history of the company or country, in case it has defaulted in the past, and to the rating given by the agencies we have seen above.
• Market conditions and possible changes: on many occasions, debt issuers have solvency problems once they have already issued bonds due to some external shock. For example, as happened during the COVID-19 pandemic or in 2012, when Spain was almost bailed out. Therefore, it is essential not only to pay attention to the issuer, but also to the possible risks in the markets.
• Internal Rate of Return (IRR) with respect to the risk-free bond: when talking about the profitability of a bond, not only is the solvency of the issuer taken into account, but it is also compared with the profitability offered by another risk-free asset. In other words, the yield on a bond (IRR) measures in a way how much more an issuer has to pay to convince the investor to buy its debt and not to buy less risky debt. This implies not only measuring the issuer of the debt, but also the evolution of this ‘risk-free asset’, because if it raises its price it will also raise what the rest have to pay.
• Recovery rate of the bond: this is a key term when the issuer in question begins to have payment problems and indicates the amount of money that the holders of its debt receive when this shock occurs.

inbestMe, a good choice to mitigate credit risk

When setting up a portfolio, it is essential to have an exhaustive control over the credit risk, since our savings are at stake. However, sometimes it is not easy to do so and we need a third party. In this case, platforms such as inbestMe appear: firstly, because they are recognized firms where your money is safe. Secondly, because it generates automated portfolios, it is a robo-advisor, which adjusts perfectly to the profiles of the clients and has behind it an expertise that ensures compliance. Finally, because it offers all these advantages and more at very competitive prices.

So, if you want to add to your portfolio the best range of bonds with the maximum guarantee and profitability, open your inbestMe account now and start seeing your savings grow at your desired rate.