Chapter 4 of 4
Credit ratings and default risk
7 min read
Government borrowers rarely default. Companies sometimes do. A credit rating is a rating agency's opinion on how likely a borrower is to pay on time.
Reading ratings
- AAA: the highest safety.
- AA and A: strong to adequate safety, with more sensitivity to bad conditions.
- BBB: the lowest grade still considered investment grade.
- BB and below: speculative or 'junk', where default risk is meaningfully higher.
- D: the borrower has defaulted.
The spread
A corporate bond pays more than a government bond of the same maturity. The extra yield, called the spread, compensates you for credit risk. A wide spread means the market sees greater risk, not a bargain.
Why a high yield is a warning
- A government bond yields 7%. Two company bonds of the same maturity yield 7.5% and 11%.
- The 11% bond is not a better deal; the market is demanding 4 extra points because it fears the borrower may not repay in full.
What can go wrong
- A downgrade makes existing bond prices fall even if the borrower still pays.
- A default can mean losing part or all of the principal.
- Low-rated debt can be hard to sell when you need to.
Debt funds and credit
A fund's factsheet shows the percentage held in each rating. A portfolio concentrated in AAA and government securities is conservative; one reaching for yield in lower ratings is taking more risk, and its past returns may not repeat.
Key takeaways
- Ratings from AAA to D rank default risk; BBB is the lowest investment grade.
- A wide spread over government yields reflects higher perceived risk.
- Check the credit mix on a debt fund's factsheet.
This content is for education only and is not investment or tax advice. Mutual fund investments are subject to market risks; read all scheme-related documents carefully.