The subject of convexity is also applicable to bond portfolios, and is of some importance to the institutional fund manager who wishes to model how their portfolio might behave in different interest rate scenarios. For the purposes of the private investor, the subject is of rather less importance.

      Chapter 6: Credit quality and ratings

      Credit quality is a measure of the issuer’s ability to service and repay its debt. In the case of gilts, US Treasury bonds and other high-quality government debt, the chance of default is low, even given the West’s addiction to deficit funding. However, for issuers lower down the food chain than our sovereign masters, the wise investor must do some homework. Credit ratings will vary greatly from one issuer to another and even between individual bond issuers from the same company, depending on the bond’s seniority within the creditor hierarchy.

      Buying a bond is a serious business. You will be lending money to an organisation, and you should be comfortable that this organisation has both the ability to service the debt and to repay it in due course. Before we consider the methods of comparing and evaluating credit quality, let us consider what type of loan we will be making.

      Types of loan

      Secured lending

      These types of bonds are comparatively rare but here the bondholders will have a direct charge on an individual pool of assets (often real estate). This, of course, will be of little help if the company is unprofitable and unable to pay the interest due on loans. However, in the event of a bankruptcy, secured lenders will be at the head of the queue and are likely to make a full recovery of their investments.

      Senior Unsecured

      The most common type of bond. As a senior unsecured bondholder you will rank ahead of the equity holders and subordinated bond holders (see below). However, senior bond holders will stand behind the secured lenders (above) in the event of the company winding up.

      Subordinated

      Subordinated bonds are securities where the investors claim on the company’s assets has been pushed down the credit hierarchy. As such, they are a higher risk than senior or secured bonds from the same organisation.

      These types of bonds are generally issued by banks and insurance companies, who have large and complex balance sheets. Such bonds will typically yield more than the two senior bonds above, and show higher volatility. [You can read more about these bonds in chapters 11 and 13.]

      And how about government bonds?

      Investors should consider that the senior/subordinated structure does not apply to government bonds. Indeed, many aspects of normal commercial law do not apply to governments, and this is something to bear in mind when dealing with the more risky end of the sovereign bond markets.

      Note – seniority is not everything. Better a subordinated bond from a high-quality, conservative borrower than a senior bond from a more speculative issuer.

      Credit ratings

      Credit rating agencies

      You may have your own knowledge and views on a company’s ability to repay debt – perhaps gained from your experience in the equity market. Alternatively, you can view the credit rating assigned to issuers by several of the credit rating agencies, who deploy considerable resources to assess both the issuer and the individual bond.

      It is in the interest of bond issuers to obtain ratings from the credit rating agencies. Without this stamp of approval from an independent body, the bonds will be hard to sell. Indeed, most institutional investors will be unable to purchase a bond that does not have a rating. There are two main international credit ratings agencies, namely Moody’s and Standard & Poor’s. A simple first stage check on a bond’s quality will be to reference such ratings.

      Credit ratings are the criteria used by most banks and fund managers when establishing the suitability of a bond as an investment but, remember, situations change quickly, and so can credit ratings. Such ratings, and the change thereof, will be announced via RNS (the Stock Exchange’s Regulated News Service) and other publicly accessible news media, but bear in mind that the ratings agencies are notorious for being lagging indicators of credit quality. It is likely that the price of the bond will have moved some time before the change in rating.

      You can look up the rating of most bond issuers on www.moodys.com and www.standardandpoors.com. An honourable mention should also go to Fitch IBCA (www.fitchratings.com). Private investors are able to register for free on these websites and view the allocated ratings.

      The cost of ratings

      The cost of obtaining a credit rating is not insubstantial, particularly for one-off, smaller or infrequent borrowers. Frequent borrowers will generally negotiate a package deal whilst large borrowers will find a rating cost effective on a per-unit basis. Of course, a good rating will drive down the cost of borrowing but the cost/benefit ratio may not be effective for some borrowers. The borrower may also have to devote a significant amount of management time to the ratings process.

      The rating agencies are somewhat close-lipped about the cost of providing their testimonial. Moody’s documents state that the issuer has agreed,

      “to pay to MIS for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,500,000.”

      Market sources tell me that a typical cost