Source: Standard & Poor’s

      As can be seen, default rates can vary greatly over different time periods.

      At risk of making a rather over-optimistic and sweeping statement, I would say that it is rare to experience a default in an investment grade bond. Note, however, that a bond bought with a double-A status may well be downgraded several times before default, so credit ratings are not a “fit and forget” component of risk management.

      Finally, consider that default may not be a total loss situation. In portfolios that I have held (or advised on) over the years, I would estimate that recovery rates have been in the range of 20 to 80p in the pound, although recovery of this debt frequently takes some years to achieve.

      Non-rated issues

      I recently surveyed the readers of my website for their opinion on preferred ratings bands and sectors. 20% of respondents replied that they did not follow the credit ratings agencies, preferring to formulate their own view independently of any rating given. This is not unreasonable. Many private investors have very good judgement and are not slaves to industry orthodoxy. That opens the possibility of buying unrated issues, an area where many fund mangers will be unable to tread.

      Consider that an unrated bond is not necessarily a bad credit. There are some issuers who are of the opinion that their name and creditworthiness are sufficient to stand alone without the imprimatur of Moody’s or Standard and Poor’s. A good example of this would be the mutually-held John Lewis Group, which the market prices as a high-end investment grade corporate, in spite of not having a rating. Tesco Bank, the banking subsidiary of the supermarket group, is also unrated (although its parent carries an investment grade from the major agencies).

      However; be advised. There is a danger, particularly with private investors, to confuse the product with the issuer. Whilst John Lewis is in good shape, there are numerous producers of well-loved and luxury goods that operate on thin margins, low profitability and a stretched balance sheet. With unrated issuers, take a good long look at the reports and accounts before acting.

      Making the credit decision

      Credit ratings

      Credit ratings and their interpretations are covered earlier in the chapter and it is fair to say that these ratings should be the first port of call. The credit rating agencies are far from perfect but their opinion is generally valid, and, more importantly, their opinion will be closely followed by institutional investors.

       Tip

      Look out for the momentum of upgrades and downgrades. Re-ratings often come in series, and a drop from single-A to triple-B may not be the end of the story.

      Do-it-yourself credit analysis

      In addition to considering the company’s credit rating, you may well wish to perform your own credit analysis, whether the company be rated or otherwise. In some cases, there will not be a credit rating to rely on, the aforementioned John Lewis being a good example.

      The first tool to apply is common sense: do you trust the management? Are the company’s activities, accounts and its balance sheet transparent? The next step is to download a copy of the company report and accounts and start digging. The advent of the internet has made this process much more accessible to the private investor. The company’s own website is the first port of call, but there are many resources that can be employed [See the appendix for further information].

      On the flip side, be wary of confusing the product with the company. As mentioned above, private investors often feel well-disposed towards known high-street brands, and that goodwill may spill over into their analysis of the company’s debt. Try to stay objective.

      The subject of credit analysis is a complex one, but if I can attempt to boil it down to a few main points, I would focus on the following.

      Table 6.3: the main credit questions for investors