Because a bond entitles its owner to income and capital return, the strength and security of the institution borrowing the money is of prime importance. One risk that bond holders are exposed to is the risk that the institution defaults on the bond. This is the same risk that any lender faces. A bank attempts to assess how creditworthy a person is before lending that person money, because the bank must always be concerned that the borrower might default on the loan.
When you invest in bonds, you are in effect taking on the role of the banker lending money. And as banks do, you must manage the risk that your borrower (the institution issuing the bond) won’t default.
It is primarily due to this potential default risk that bonds have their own risk vs. reward pyramid.
At the bottom of this pyramid there is less risk of a default. Here, we find bonds issued by institutions believed to be the most secure. There are few more secure bonds than those issued by the U.S. Federal government. Because of this, you find these bonds at the very bottom of the pyramid.
Higher up on the pyramid, you find bonds issued by large corporations: those that have been in business for a long time, with stellar financial strength and a long history of creditworthiness. And still higher on the pyramid, you find bonds issued by smaller, newer corporations with less of a track record. Higher still will be bonds issued by some corporations and perhaps even some municipalities that are facing financial difficulties.
On the risk side, the idea is that as you move up the pyramid, there is a greater risk of default, because the bonds are issued by less and less creditworthy corporations and institutions. On the reward side, the interest rates you earn on these bonds also increases as you move up the pyramid.
The more secure and creditworthy the bond issuer is, the less chance they will default, and the easier it is for them to attract purchasers of their bonds. The easier it is to attract a purchaser because of creditworthiness, the less interest the issuer will have to pay on their bonds. Again, U.S. Federal Government bonds are at the bottom of the pyramid, and the reason is both that the risk of default is so low and also that the reward they provide, or the interest they pay, is low as well.
As you move up the pyramid, the risk of default increases, and because of it, the bond issuers have a more difficult time attracting purchasers. To get others to purchase their bonds, the bond issuers have to reward them for taking higher risk by providing a higher rate of interest paid.
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