Credit ratings and the eight bond risks

An opinion on default

A credit rating is an agency's opinion of how likely an issuer is to pay on time. Canada's domestic agency is Morningstar DBRS; the two global names are S&P Global and Moody's. Each uses a letter ladder. Rate three issuers: the Government of Canada — AAA (DBRS and S&P) / Aaa (Moody's), the top rung; Tamarack Foods — BBB / BBB / Baa, the lowest investment-grade band; Cobalt Ridge Mining — BB / BB / Ba, the first speculative (high-yield, "junk") band.

The investment-grade boundary is the line most questions sit on. On S&P's scale the last investment-grade rung is BBB−; on Moody's, Baa3. On the DBRS scale the equivalent rung is written BBB (low) — take that as given here; the scale itself is published by Morningstar DBRS. Below the line, many pension funds and insurers may not buy, so the yield jumps — the spread over GoC is the market's own rating, updated by the second.

Three things a rating is not: it is not an opinion on price risk — a AAA 30-year bond can lose a fifth of its value in a rate shock; it is paid for by the issuer, so read it as a considered, conflicted opinion; and it lags — the spread usually widens before the downgrade arrives.

The eight risks

A bondholder carries eight distinct risks, and the paper names each by its story:

1. Interest-rate (price) risk — rates rise, the price falls (Lesson 8.5). Larger for longer terms and lower coupons; largest for strips.
2. Reinvestment risk — rates fall, and the coupons you receive earn less when reinvested. Larger for higher coupons and longer holdings; zero for a strip held to maturity.
3. Default (credit) risk — the issuer fails to pay. The rating's subject.
4. Liquidity (marketability) risk — you cannot sell without a large concession. Small for GoC benchmarks, large for a small corporate issue.
5. Inflation (purchasing-power) risk — fixed dollars buy less. The real return bond's reason to exist.
6. Call risk — the issuer redeems when rates have fallen, and you are handed cash at the worst moment to reinvest it. Call risk's consequence is reinvestment risk; the cause is the call.
7. Currency (exchange-rate) risk — a foreign-currency bond's coupons and principal translate into fewer Canadian dollars if that currency falls (Lesson 8.8).
8. Sovereign (political) risk — a foreign government changes the rules: capital controls, taxes, repudiation.

The two that move against each other

Bigel's two-row table is the point of the lesson. Rates rise: price down (interest-rate risk bites), reinvestment income up. Rates fall: price up, reinvestment income down (reinvestment risk bites). Every bond carries both, and they offset — the balance point, where the two effects cancel over a chosen horizon, is duration, which Module 10 introduces. A holder who sells before maturity fears rising rates; a holder who reinvests coupons to maturity fears falling ones.

Name the risk

A 30-year GoC bond loses 18 % when yields jump — interest-rate. A 6 % corporate is redeemed at 103 after yields fall to 4 % — call. A US-dollar bond's coupons buy fewer CAD after the USD weakens — currency. A small issue can only be sold five points below the last trade — liquidity. A 3 % bond's coupons must be reinvested at 2 % — reinvestment.