Any investment takes risks, and higher risks typically correlate with higher returns. However, when investing in bonds, one should avoid taking unnecessary risks as much as possible.
The size of the risk is also a key factor affecting bond returns, and since the main return from bond investment comes from fixed income, the greatest fear is the irregular interest payments and the inability to repay the principal the default risk.
Default risk is the biggest risk in bond investment.
Bond default risk refers to the situation where the issuing country/company is unable to pay the interest or principal.
Since bond returns are determined based on ‘the size of risk’, investors typically refer to the credit ratings of bonds before investing. However, credit ratings are not a guarantee of profits; it’s just using a more objective perspective to select bonds.
Bonds with lower risk offer lower returns. Investors can invest in them with more peace of mind but earn less; bonds with higher risk offer higher returns, allowing investors to potentially earn more, but they also take a higher risk of encountering dangerous situations.
For example, consider two potential borrowers, which one will you lend funds to?
Investor A is a government employee with 10 years of experience and a stable income and wants to borrow money from you at a 1% interest rate.
Investor B is a temporary worker with an unstable income and wants to borrow money at a 5% interest rate.
Comparatively, Investor B offers better loan terms, as lending to them would yield higher interest. However, one must also consider the higher risk of default with Investor B, which could lead to losses far exceeding the potential profits. This judgment is mainly based on Investor B’s lower credit rating.
The most renowned international credit rating agencies are Standard & Poor’s (S&P), Moody’s, and Fitch Ratings, all three of which have similar standards. Generally, S&P’s standards are sufficient for reference. To simplify risk classification, bonds rated ‘A’ and above, including AAA, AA, A, and BBB, are considered high-quality bonds, while non-investment grade bonds are typically rated BB, B, CCC, and below.
It is recommended to choose bonds rated ‘A’ or at least above BBB (e.g., U.S. Treasury bonds, investment-grade bonds), as they generally offer higher stability.