When you invest in a bond, you want to know the likelihood that the bond issuer will be able to make principal and interest payments on time. That is, you want to know the credit quality of the bond.
Moody's Investors Service, Inc., and Standard & Poor's Corporation are the best-known companies that assign credit ratings. Their ratings are influenced by such factors as a bond issuer's financial strength (cash on hand, profitability, etc.) and its past record of repaying debts.
Generally, the lower a bond's credit rating, the higher the interest rate its issuer must offer lenders to compensate them for the risk that the borrower will default.
The following table shows the range of credit quality ratings assigned by Moody's and Standard & Poor's.
Corporate bonds are debt instruments of varying credit quality issued in a range of maturities by corporations.
Corporate bonds vary according to:
Most corporate bonds are assigned a letter-coded rating by independent bond-rating agencies such as Moody's Investors Service, Inc., and Standard & Poor's Corporation. The rating indicates the likelihood that the issuer will pay interest and repay the principal in full and on time. Bonds rated Baa or higher by Moody's, or BBB or higher by Standard & Poor's, are called investment-grade bonds. Bonds rated Ba or lower by Moody's, or BB or lower by Standard & Poor's, are known as high-yield bonds (because of the higher interest rates they must pay to attract investors) or "junk" bonds (because of the possibility that the issuer will default).
Corporate bonds range from short-term (less than 5 years) to intermediate-term (5-10 years) to long-term (more than 10 years).
Benefits of Corporate Bonds
Corporate bonds generally provide higher interest income than Treasuries and agency bonds because they are considered to be less safe than government securities, and the market rewards investors for assuming even a small amount of additional risk.
Drawbacks of Corporate Bonds
During periods of falling interest rates, corporate bond issuers may prepay, or call, their loans before maturity in order to reissue the loans at a lower rate. You as lender, then, must reinvest this prepaid principal sooner than you had anticipated-and possibly at a lower interest rate.
You could lose money if a bond issuer defaults-that is, fails to make timely payments of principal and interest-or a bond's credit rating is reduced.
The credit quality or market value of your bonds could suffer in response to an event such as a merger, leveraged buyout, or other corporate restructuring.
The interest income on your corporate bonds (unlike the interest income on Treasuries and some agency securities) is taxable at the federal, state, and local levels.
Interest Rate Risk.
The market value of your bonds could decline due to rising interest rates. (In general, bond prices fall when interest rates rise-and rise when interest rates fall.)
The interest income you earn from a bond investment remains the same over the life of the bond. The value of that money could be eroded by inflation.
Measuring Volatility With Duration
Knowing a bond investment's duration helps you gauge its volatility, or expected price fluctuations.
Duration measures the sensitivity of bond (and bond mutual fund) prices to interest rate movements. Measured in years, duration indicates how much a bond's price will fluctuate with each percentage change in interest rates.
Many investors confuse duration with maturity-the length of time until a bond investor is repaid his or her original investment. Maturity factors into the calculation of duration (the longer a bond's maturity, the more sensitive it is to interest rate changes). But a bond's coupon (or interest rate) and call status figure in too.
Fortunately, you don't need to know how to calculate duration. You only need to know how to use it.
Duration, Interest Rates, and Bond Prices
In general, the longer a bond's duration, the more its price will decline when interest rates riseand the more its price will rise when interest rates fall.
To calculate the percentage change in a bond's price (or a bond fund's share price), multiply the bond's duration by the percentage change in interest rates, as in the following table below.
Remember the risk/reward trade-off: You are generally paid a higher interest rate in return for buying a bond with a longer duration and greater interest rate risk.
Using Duration to Manage Risk
Duration can be a useful risk management tool if you have a clearly defined time horizon. A rule of thumb is to match your investing time horizon with the duration of your bond investment. For example:
If you're investing money that you want to use for a down payment on a house in two to four years, consider a bond investment with a duration of two to four years.
If you're saving for retirement and plan on working for the next decade, look for a bond investment with a duration of about ten years.
Bond funds maintain an average duration by purchasing new bonds to replace bonds that mature. Therefore, you should reevaluate your investment as your time horizon shortens, because your fund's duration and your time horizon may no longer be in sync.
Of course, duration tells you only what will happen to bond prices when interest rates fluctuate; it doesn't tell you when or how interest rates will change. And using duration helps you limit-not eliminate-the risks of a bond investment.