Bonds Essence - 6
Understanding default risk to better prepare
for market changes
In times of economic stress and market uncertainty, bonds make good investment sense, as they generally offer
predictable cash flows in the form of coupon payments, as well as principal repayment at maturity, provided that there is
no default. So, if you are planning to invest your hard-earned money into bonds, you first need to understand what is
default risk.
What is default risk
So which bonds have the least risk in general?
Default risk occurs when companies or individuals are
unable to pay the contractual interest or principal on their
debt obligations. In the case of bonds, default risk could
come from the issuer’s failure to repay the principal or
make coupon payments as agreed.
Issued by the US government, US Treasuries are usually
regarded as the safest and have little to no risk of default.
Default risk usually rises during times of economic stress.
This is because it is common for companies to “borrow”
money by issuing bonds to investors for funding their
working capital requirements, or for business expansion
purposes. At times of market downturn, an issuer may
default due to their inability to raise new debt to roll over
or repay old debt.
How to assess default risk
Credit ratings are the most common tools used for
assessing bond default risk. Essentially, the higher the
credit rating, the lower the probability of default. The two
most recognised rating agencies that assign credit ratings
to both bond issuers and bond products are Moody's
Investors Service (Moody’s) and Standard & Poor's (S&P).
When assigning a credit rating, these rating agencies
focus on an issuers’ overall financial conditions as well as
that of the industry in which the issuer operates. A rating
represents the opinions of the rating agency at a particular
point of time. Ratings on individual issuers are
continuously reviewed to reflect any industry changes or
company developments, and these changes in ratings can
have a distinct effect on an issuer's market price.
Bond issues are categorised mainly as either "investment
grade" or “non-investment grade”:
Investment grade bonds (for Moody's from Aaa to Baa3,
and for S&P from AAA to BBB-) are generally more
popular among investors. This is because these bonds
are typically by comparison the most capable of honoring
their debt obligations with principal repayment and interest
payment, and are generally the least likely to default.
Similarly, investment grade municipal bonds also
normally have a very low chance of default as they are
backed by local governments.
By comparison, investment grade corporate bonds
have a higher risk than US Treasuries and municipal
bonds but are still considered less risky versus junk
bonds.
Non investment grade junk bonds have much higher
risk of default and are usually purchased for speculative
purposes. Junk bonds, or speculative bonds, typically
offer interest rates higher than safer government issues to
compensate for the increased level of risk.
Unrated bonds are generally regarded as the most risky
type of bonds and are more vulnerable to default.
Minimising the credit downgrade or default risk
Credit ratings may change over time, due to either
changes in the financial status of the bond issuers or
changes in market conditions.
During economic downturns, the market landscape may
change dramatically and bond issuers may be subject to
higher downgrade or default risk. Therefore, the need for
active risk management is key. Professional fund
managers usually have a team of credit research experts
to regularly assess the credit quality of bond issuers and
bond products. In addition, they will mitigate credit risk by
adjusting the product mix in their managed portfolio and
striking a better balance between risk and return.
As such, investors should diversify their investments
instead of putting all their eggs into one basket. Bond
funds, which invest in a portfolio of bonds, could be an
option for diversification.
Below investment grade bonds (for Moody's Ba1 or below,
and S&P BB+ or below) are usually more attractive to
aggressive investors who are willing to accept greater
degree of credit risk in exchange for significantly higher
yields.
Investment involves risks and past performance is not indicative of future performance. The document is prepared for general information purposes only. All
views expressed cannot be construed as an offer or recommendation by HSBC Global Asset Management (Hong Kong) Limited ("AMHK”). AMHK and HSBC
Group shall not be held liable for damages arising out of any person's reliance upon this information. Any person considering an investment should seek
independent advice on the suitability or otherwise of the particular investment. AMHK has based this document on information obtained from sources it
reasonably believes to be reliable. However, AMHK does not warrant, guarantee or represent, expressly or by implication, the accuracy, validity or
completeness of such information.
Issued by HSBC Global Asset Management (Hong Kong) Limited