Measuring the Risk of Bond Default - dummies

By David Stevenson

Bond investors in the UK worry about risk and in particular the chance of issuers defaulting on their bonds (which usually means that bond investors don’t get their money back). Therefore, concerns about default (plus future inflation rates) have a huge impact on bond pricing.

In fact, many bond investors are more paranoid than virtually any other kind of investor and are reluctant to take on extra risks.

Unlike most equity investors, who accept risks such as shares going up and down and companies stopping and restarting dividends in return for potential extra returns, bonds are supposed to be safer and less volatile in terms of price – which also helps explain why returns on bonds have been more modest over the last few decades.

Unsurprisingly, therefore, investors in bonds require reliable ways of measuring risk. Credit-risk measurement is available through the research of a number of different credit rating agencies – namely S&P, Moody’s and Fitch.

Each of the agencies has its own specific measures and methodology, but all produce ratings that tend to cluster together and roughly mean the same thing. This table compares the ratings as they move from the highest grade (safest), which is usually AAA, through to the lowest grade, which is a company in default (usually marked C or D).

These ratings can change over time. For example, the government of South Korea found itself downgraded from AA‒ to BBB‒ in just a few years.

Central to this dynamic process is regular research. Here’s S&P’s research process in some detail:

  1. Issuer requests a rating prior to sale or registration of a debt issue.

  2. S&P analysts conduct basic research, including meeting issuers to review in detail the key operating and financial plans, management policies and other credit factors that impact the rating.

  3. Analysts present findings to S&P rating committee of five to seven expert voting members.

  4. Rating committee decides rating.

  5. Issuer notified and has the opportunity to appeal prior to the rating publication.

  6. Rating published.

  7. S&P monitors issuers for at least one year from date of publication; issuers can elect to pay S&P to continue surveillance thereafter.

Differences between Bond Credit Ratings from Different Agencies
Moody’s1 S&P2 Fitch IBCA2
Investment grade
Highest grade Aaa AAA AAA
High quality (very strong) Aa AA AA
Upper medium grade (strong) A A A
Not investment grade
Lower medium grade Ba BB BB
Low grade (speculative) B B B
Poor quality and may default Caa CCC CCC
Very speculative Ca CC CC
No interest being paid or bankruptcy C D C
In default C D D

1The ratings from Aa to Ca by Moody’s can be modified by adding 1, 2 or 3 to show relative stature of the company

2The ratings from AA to CC by S&P and Fitch may be modified by adding a plus or minus sign to show the relative strength within the band