CREDIT PART TWO: CREDIT AS A LENDER
As an individual, it’s unlikely that you’ll be an original lender of credit. But that’s not to say you can’t reap the same benefits.
Introducing: buying bonds.
A bond is a financial instrument. It represents a promise to repay money that was borrowed over a specific period of time (or term) with interest. When a bond is created - it’s called origination or issuance. A corporation might issue a 3 year bond in order to pay for equipment that is used to make their business more efficient. Upon issuance, the corporation would receive cash for the bonds and use the proceeds to pay for the equipment. Over the next three years, the corporation will pay its bondholders (the buyers of bonds) interest to compensate for lending them money to help grow their business. Since the bond has a 3 year term, at the end of 3 years, the corporation will give the bondholders back their original investment. Bonds can be issued by corporations, governments or municipalities, but each would do so for a different reason. Governments might issue bonds to support spending on national defense or education, whereas a municipal bond could be issued to fund hospitals, roads, or other local projects.
Individuals buy bonds primarily to earn interest over the term of the bond, with reasonable security that at the end of the term, they will receive their principal investment. Bonds are priced in comparison to what is called ‘par value’, or 100 cents on the dollar. If a bond is sold below par, there is an expectation that the bond issuer might not be able to pay its debt, or has a higher likelihood of default. If a bond is sold above par, it’s considered to be low risk, ie it’s likely that the bond issuer will be able to repay its debts . In either case, the principal investment that you receive at the end of the term is equal to par or 100. In practice, this means if you buy a one year bond at 90 cents on the dollar with a 5% interest, if the bond issuer does not default, you will receive your interest payment, your original 90 cent investment, plus an additional 10 cents.
The primary risk investing in bonds is called ‘default’, which means that the issuer, due to financial troubles, is unable to make payments on the bond. When investing in bonds, it’s super important to understand the credit worthiness of the bond issuer. Think about what a ‘credit score’ might be for a bond issuer. Questions you might ask…. Have they historically paid on time? Have there been any issues with default in the past? Is the company or government in a reasonable position to repay its debt? What would have to happen in order for the issuer to default?
Answering these questions might be challenging, which is where ratings agencies come to help. Thinking back to that ‘credit score’, there are three ratings agencies: Standard & Poors, Fitch Ratings & Moody’s who assign scores (ratings) to corporations, governments and municipalities in order for investors to better understand the inherent risks of a particular entity. Each agency uses its own metrics and ratings to independently make an assessment, resulting in one of the ratings below:
Moving from top to bottom of the above chart, Investment Grade is considered lower risk of default and Junk is considered higher risk of default. We would expect an Investment Grade bond to have a higher price than a Junk bond to reflect this perceived risk. Similarly, we would expect a Junk bond to pay a higher level of interest than an Investment Grade bond, to compensate us for that risk. It’s not only the rating that drives this opinion of perceived risk, but each of the credit agencies will also provide a forward looking outlook of positive, stable or negative.
While the rating agencies provide us with great insight into the perceived risk of a specific investment, we can’t look at ratings in a vacuum. The ratings agencies came under deep scrutiny during 2008, as many believed the agencies provided too positive of ratings. Since then, regulations such as Dodd Frank in US, as certain directives in Europe, have placed more responsibility and accountability on ratings agencies.
Thinking about risk of default in a bit more detail, we’ll give a few examples of how risk and return varies in different bonds. Generally speaking government securities have lower risk than corporate securities, but within each of these securities, there are nuances.
Comparing bonds of differing credit quality:
US government bond is considered lower risk than an Argentinean government bond. Despite running a deficit, the US has never defaulted on its debt and is globally considered as one of the safest investments. Argentina on the other hand defaulted on its debt in 2001 and has been going through restructuring since 2005. Data from the agencies shows US as Prime Debt & Argentina as Highly Speculative. Given the risk of investing in Argentinean bonds vs. US bonds, we can expect the price to be lower for Argentine bonds and interest to be higher.
The same comment can be made about corporate bonds of different qualities. Companies with lower rates often offer a “High Yield” - which means they are paying a high level of interest. For example, Unilever has an High Grade rating with stable outlook and is offering a 2.73% yield on a bond that matures in 3 years, vs. Ford Motor Credit has a Lower Medium Grade rating with negative outlook and is offering a 4.46% yield on the same bond maturity.
Comparing bonds of different terms within a single country:
If all else is equal, longer term bonds typically have higher risk than shorter term bonds. This is because you are lending money for a longer period of time - since money will be out of your pocket for longer, there is more uncertainty around if you will be paid back. As a result, we would expect to be compensated higher for a longer term. Below is the chart showing the interest rates for 2 year treasury bonds (in orange) vs. 30 year treasury bonds (in purple). The 30 year treasury bond interest rate is 3.04%, versus 2 year is 2.46%.
Comparing a US government bond vs. a state or local municipal bond:
While a Treasury Bond (or US government bond) is backed by the US government, a municipal bond is backed by the income, balance sheet and credit worthiness of a state or local government. While rare, municipalities have defaulted historically, including cases such as Puerto Rico in 2016 (the first state to ever default) and Detroit when the city filed bankruptcy in 2013.
A unique attribute of municipal bonds is that they are free of federal income taxes. Further, typically if you invest in a municipal bond of your state, you will also receive interest free of tax from your state. The below table comes from Eaton Vance, showing the difference in current yields between AAA Municipal Bonds and US Treasuries (also AAA). While the yield is lower on municipal bonds for the same rating, for those in higher tax brackets, tax-adjusted yields for municipal bonds are likely higher.
Comparing corporates to municipal bonds:
While defaults have existed in both types of bonds, generally municipal bonds are viewed as lower risk than corporate bonds. Below is a chart showing Municipal Bonds (green + blue) towards the top end of the ratings scale (Investment Grade), vs. corporate bonds (in orange) throughout the ratings scale.
Absolute interest rates are lower for municipal bonds, however again for higher income tax brackets, the tax adjusted rate is currently higher. The below chart comes from Eaton Vance - the middle column shows the yield on investment grade corporate bonds in the US vs. the bar on the right shows the municipal bonds before and after the tax adjustment.