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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.
Ratings agencies like Moody's and Standard & Poor's research and analyze
bond offerings in an effort to measure an issuer's default risk on a particular
security. The results of their work are credit ratings that investors can track
and compare with other issuers.
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
|
|
Investment
Grade Bonds
|
|
| 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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