Do Bonds Carry Default Risks?

Do Bonds Carry Default Risks?
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Though bonds are considered a relatively safe investment, there is a risk of default with bond investments. Default means a bond issuer does not make scheduled interest or principal payments to investors owning the bonds. The chance of default can range from nearly non-existent to significant, depending on the bond issuer. For example, some holders of Argentina government bonds, which defaulted in 2001, are still waiting for payment.

Bond Types

Bonds can be classified by the type of issuer. Government bonds are sold by the U.S. Treasury and the governments of foreign countries. Municipal bonds are issued by state and local governments. Corporate bonds are issued by companies as a way to raise or borrow money. These bond types will pay a wide range of yields, and the level of yield is dependent on the default risk of the issuer.

Credit Rating

The rating agencies of Standard & Poor's, Moody's and Fitch Ratings provide bond issuers with credit ratings to indicate the possibility of default on a particular bond or issuer. The agencies all use a similar rating scale with a top rating of AAA or Aaa and going down through double A, single A, into the B's and C's. The lower the rating an issuer has, the higher the possibility of default as determined by the rating agency.

Investment-Grade Bonds

Investment bonds with credit ratings of BBB -- Baa from Moody's -- and above are considered to be investment-grade bonds. Bonds with these rating levels have a low probability of default. The higher the credit rating, the lower the perceived default risk and the lower the interest rate the issuer must pay to borrow money by selling bonds. Institutional investment portfolios and banks are often limited to buying only investment grade-rated bonds to protect the assets of the portfolios.

High-Yield Bonds

Bonds with credit ratings of BB -- Moody's Ba -- and lower are non-investment grade. These bonds are often referred to as high-yield or even junk bonds. There is a significant amount of high-yield bonds issued every year, with investors attracted by the significantly higher yields these bonds pay. The tradeoff is a higher default risk. Moody's refers to non-investment grade bonds as "speculative investment risks." An investor attracted to a bond or bond fund for the extra high yield should be aware of the extra default risk involved.