When the financial crisis began in 2008, a large number of investors replaced their risky assets with fixed income securities. Since then, interest rates have remained at historic lows. Eventually, interest rates will rise and the fallout may be far worse than we’ve experienced in modern history in the United States.
In this article, the first in a two-part series, we’ll examine the characteristics of the most common types of fixed income investments and discuss the ratings behind these securities.
In Part II, we’ll conclude with a discussion on what could happen and what to do before interest rates begin to rise. Part II will also include a simple formula which you can use to calculate the loss of principal in a bond based on an increase in interest rates.
These two articles should provide you with the knowledge you’ll need to position your clients’ assets in preparation for higher interest rates.
Common Types of Fixed Income Securities
Fixed income offerings come in a variety of types. They differ by maturity, credit quality, underlying holdings, tax treatment, etc. The following table contains some general information on the most common types of fixed income securities.
It should be noted that, in many cases, the information is not entirely straightforward. For example, a municipal bond is typically issued in increments of $5,000. However, some issues may be sold in $1,000 increments.
Another example involves corporate bonds. Although most corporate bonds have a maturity ranging from 1 to 30 years, some )known as Century Bonds) have a 100 year maturity. In short, it all depends on the terms of the bond agreement.
When purchasing bonds, an investor may purchase individual bonds or select a packaged product such as a mutual fund, ETF or a closed-end fund. When selecting bonds, it’s important to understand the risk involved. For example, choosing a bond with a low credit rating will make you more susceptible to the risk of a default.
Also, it’s important to have an understanding of the future interest rate environment. I’m not implying that you should forecast interest rate trends. However, you should understand how an increase in interest rates would affect a specific fixed income investment. This will be covered in Part II of this series of Under the Hood articles on fixed income. Another important factor involves the rating of a particular issuer.
Bonds are rated based on the risk profile of the issuer. As an issuer’s risk profile rises, a higher interest rate is typically required in order to entice investors. This is very much like a borrower’s credit score. Individuals with a higher score will get a lower interest rate. Since 2008, investors have migrated toward lower credit quality issues to find an acceptable level of income. We’ll look at three of the major rating services: Standard & Poor’s; Fitch Investors Service; and Moody’s Investors Service. Each company is charged with performing the due diligence required to derive an appropriate rating for a particular issuer. The following table contains the comparable ratings that these agencies provide on bonds.
At the top of the scale are issuers rated AAA. These issuers are considered to be the highest credit quality and have very little risk of default. However, they will also pay a lower rate of interest. Fixed income securities rated below investment grade contain greater risk than investment grade securities. When a security’s rating is downgraded, its price tends to decline. However, this price decline is worse if it falls out of the investment-grade spectrum of ratings.
To illustrate, if you owned a security rated BBB- by Standard & Poor’s and it was downgraded to BB+ (i.e., just below investment grade), its price would decline more than if it had fallen from AA to AA-.
The credit quality of the issuer is extremely important in several respects. Issuers in the bottom of the rating spectrum are already in default and investors will likely suffer a substantial loss.
The ultimate goal of a bond rating system is to provide investors with an accurate and unbiased risk assessment. This is especially true since bond ratings play such a pivotal role in determining an issuers borrowing cost.
To recap, we’ve examined the general characteristics of the most common types of bonds. We have also discussed the rating structure of three major rating agencies. In Part II we’ll discuss bond maturities, credit qualit, and other factors which influence bond prices. We’ll also look at the formula used to calculate the price decline of a bond when interest rates rise.
In summary, since interest rates have been so low for so long, the future of this once-bright asset class is rather dim. Therefore, if you have clients in bonds, including bond funds, you’ll want to follow along so you can better protect them against a loss of principal when rates rise.