From Ken Little,
Your Guide to Stocks.
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Bonds are supposed to be the more conservative portion of most people’s portfolio – there to produce income and offset the volatility of stocks.

However, if you’re not careful investing in bonds can be as risky as any high-flying tech stock.

Let’s look at some of the known facts about bond defaults. You can rank the chance for default by bond type:

• U.S. Treasury/agency – almost no chance for default
• Municipal bonds – investment grade bonds have very slight chance of default (one analysis showed less than 0.05% over a 30-year period)
• Corporate bonds – investment grade bonds have a higher risk, but still low
• Junk bonds – below investment grade have much higher risk
• Foreign bonds – may have a high risk
• Unrated bonds – highest risk of all

Of course, the interest rates paid by these bonds go up as the risk rises. That should be your first red flag. If a bond offers an interest rate that is way off the market, it is because there is a high degree of risk involved.

Another factor that correlates to default is the bond’s length to maturity. The longer a bond hangs out there the higher the risk of default.

This makes sense when you think about it. The longer a bond issuer is exposed to market or economic factors, the greater the odds are that something bad will happen.

Ratings

The most important indicator of a bond’s potential to default is its ranking by one or both of the two most recognized bond-rating services.

Moody’s Investors Service and Standard & Poor’s are the two premiere bond-rating services. If one of these services does not rate a bond, I would pass on it.

The two companies study bond issuers and rate them on their creditworthiness. Here is an explanation of their rankings:

Investment Grade – Highest Grade:

• Moody's – Aaa
  These bonds are judged to be of the best quality. They carry the smallest degree of risk. Interest payments are protected by an exceptionally stable margin and principal is secure.
• S&P – AAA
  The issuer’s capacity to meet its financial obligation on the bond is extremely strong.

Investment Grade – High Grade

• Moody's – Aa1, Aa2, Aa3
  These bonds are judged to be of high quality by all standards. Margins of protection may not be as large as in Aaa securities.
• S&P – AA+, AA, AA-
  The issuer’s capacity to meet its financial obligation on the bond is very strong.

Upper Medium Grade

• Moody's – A1, A2, A3
  These bonds possess many favorable investment attributes. Factors giving security to principal and interest are considered adequate.
• S&P – A+, A, A-
  Although these bonds are somewhat more susceptible to the adverse effects of changing economic conditions, the issuer’s capacity to meet its financial obligations is strong.

Medium Grade

• Moody's – Baa1, Baa2, Baa3
  The bonds lack outstanding investment characteristics and have speculative characteristics as well.
• S&P – BBB+, BBB, BBB-
  Adverse economic conditions are more likely to lead to a weakened capacity of the issuer to meet its financial commitment.

Both services continue their rankings for lower rated bonds, but unless you are into speculating, I suggest you stick with issues that fall into one of the categories above.

Remember, a bond’s rating can change at any time if circumstances change. Just because the services rated a bond at one level when issued doesn’t mean it can’t lower the rating if some adverse condition arises.

Conclusions

What conclusions can we draw about the potential for default?

• U.S. Treasury issues are your safest bet
• Municipal bonds with an investment grade rating have a very low incidence of default.
• Corporate bonds with an investment grade rating have a good record but slightly higher risk of default
• The higher the rating the less likely the bond will default
• The risk of default grows with the length to maturity (except for U.S. Treasury issues)
• Non-rated bonds are highly speculative