What is the credit quality risk

Bonds - basic knowledge

What influence does the credit rating have on bonds?

While bonds are generally considered safe investments, there are actually not inconsiderable risks. In addition to a price and interest rate risk, there is also the risk that an issuer (debtor) can no longer meet its obligations and cannot repay interest or even the borrowed capital. Creditworthiness is also known as creditworthiness. This creditworthiness is determined by special rating institutes (Moody's, Standard & Poor's, Fitch) and checked at regular intervals. The creditworthiness is reflected in the amount of the return. A rule of thumb says: the higher the return, the worse the credit rating.

If an issuer with a bad credit rating wants to borrow money, it must offer investors (creditors) higher interest rates in return for the increased risk of default. Bonds with a very high credit risk are also known as junk bonds. Although they offer very high returns, they are a highly speculative form of investment.
Conversely, the issuer with a very good credit rating like the USA or Germany does not see the need to offer investors high interest rates. Due to the low probability of default, the credit rating is very good.

The creditworthiness of a bond determines the difference in interest rates compared to so-called reference bonds (benchmark). Often government bonds with the highest credit rating, i.e. the lowest probability of default, are used as reference bonds. The difference in interest rates between a bond with a low credit rating and a reference bond with a comparable term is known as the credit spread. It is practically the risk premium that the issuer has to pay the buyer of a bond compared to a bond from an issuer with a first-class credit rating. This is expressed either in surcharges on the current risk-free interest rates or in discounts in the price. This risk premium is, so to speak, the insurance that the issuer pays the investor to cover the risk of becoming insolvent.

A change in creditworthiness therefore also affects the price development of a current bond. If the credit rating of a bond improves due to an upgrade by a rating agency, the price of the bond generally rises due to increased demand from investors. Conversely, the bond yield decreases. On the other hand, a credit rating downgrade leads to a decline in the price of the bond and an increase in the yield. If there is actually a default, as in previous years with Argentina, the bond price falls to a level of 20 percent of the nominal value or below.

Therefore, the general rule is: the higher the return, the higher the risk. For example, a high nominal interest rate on foreign bonds may indicate that the issuing country has a comparatively low credit rating. In fact, if the nominal interest rate is very high, the failure of an issuer, i.e. a company or a country, and thus the total loss of high-risk bonds, cannot be ruled out.