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Bond investors: Look at credit quality, spreads

As fixed-income investors explore their fixed-income options amid persistently low interest rates, Marc Amateis explains why they should consider credit quality. Marc spoke with Joel Dresang in a Money Talk Video. A transcript of their conversation follows.

Joel Dresang: Marc, when you’re talking with investors about the fixed-income or the bond side of their investments, a lot of times you talk about credit quality. What is that?

Marc Amateis: The bond market is very diverse: Government bonds, corporate bonds, high-yield, municipals, etcetera. But what we’re really talking about is the quality of the debt that’s issued. Is the issuer able to repay the debt? How likely are they to repay the debt? Credit quality is a representation of that.

Joel: And how do you know what the quality of the credit is?

Marc: Well, there are two main credit-rating agencies – Standard & Poor’s and Moody’s – and they will look at a bond offering, and they will give the bond offering a credit rating, starting with AAA and going all the way down to C, which is the low end of high yield or sometimes called junk.

Joel: And the riskier ones would have to pay higher yields. If you’re taking a bigger risk, you’d expect more back for it.

Marc: Sure. That’s exactly right. If an investor is going to invest in one of those companies with a lower credit rating, they’re going to demand a higher rate of interest – a higher yield – to buy that bond. So the company’s going to be forced to pay that yield.

Joel: So, we also have a graphic showing the spread between the yields for different grades of bonds. And that spread doesn’t stay the same all the time. Sometimes it’s narrower. Sometimes it’s wider.

Marc: That’s right. Think back to the subprime mortgage crisis. Fear drove money into the highest rated bonds. And when that happened, the spread between high-level investment-grade credit and lower-grade or junk credit got extremely wide.

On the other hand, when the economy is doing well, and there aren’t any problems in the financial system and people feel good about being repaid, even on lower-quality debt, they’ll move into those areas, and those spreads will narrow.

And one thing you want to be careful of is when those spreads get too narrow, to the point where you’re not being compensated for the additional risk that you’re taking by going into the lower-quality credit. Then it’s time to step back and say, ‘Wait a minute. It’s not worth the risk, and this might not be the time to jump in or to add. Or maybe even, this might be the time to get out of some of that kind of debt.’

Joel: So within one investor’s fixed-income portfolio, they would have a variety of different credit qualities for the bonds that they’re in?

Marc: Exactly. At different times, different areas of the bond market, different qualities of the bond market may be a better buy than others. But overall, investors usually want high credit quality in their portfolio because that’s really your safety net. We like to take most of our risk on the stock side and use the bonds as a method of really controlling risk in the overall portfolio.

Marc Amateis is vice president of Landaas & Company.

Joel Dresang is vice president – communications at Landaas & Company.

Money Talk Video by Peter May
(initially posted June 26, 2014)

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