Debt is part of the world’s financial DNA.
When governments and corporations need to borrow money, they issue debt securities. Investors, like you, can buy them — usually in the form of bonds or bond funds. You’re lending them money, and they agree to pay it back to you, plus interest.
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But not all borrowers are created equal. When you consider an investment in debt, you need to understand the likelihood that the borrower will pay you back. This is called their ‘risk of default’.
For individuals, it’s called the FICO credit score. Banks and credit bureaus use this score to determine an individual’s risk of default. Similarly, credit rating agencies give most governments and corporations a credit rating to help you understand their risk of default. These numbers and letters help you understand how risky it is to buy their debt.
The credit rating also influences the interest rate of the bond — how much they have to pay you in addition to the original bond amount. Credit ratings above certain levels are categorized as ‘investment grade’ – generally meaning a lower interest rate. It’s less expensive to borrow money when you’re unlikely to default. On the flip side, a very risky bond – called a distressed or ‘junk’ bond – will likely have a higher interest rate because it has a higher risk of default.
Let’s look at a few examples:
- The U.S. Government. It’s been around for centuries and currently has the largest economy in the world. It can even tax citizens to pay back debt. An investment in treasury debt is considered to be pretty much risk free.
- A large corporation with an ‘investment grade’ credit rating. It may not have been around for centuries, but it will often have a history of strong earnings, innovative products, market leadership, and transparent governance structures. The risk of default is higher than the U.S Government, but still very low.
- Your cousin Ned. He doesn’t have any income and hasn’t had a steady job in years. To add to that, he’s been taken to collections for missing rent payments. Ned probably has a very low credit score, and therefore a high risk of default.
One of the primary goals of investing in ‘investment grade’ bonds is to preserve your capital and receive a steady flow of income payments over the long term.
Interested? Here are four ways you can add bonds to your Stash:
1. Uncle Sam – an investment in U.S. Treasury bonds.
The US Government has a rock solid credit rating — AA+, just a notch below superior. As the largest economy in the world, and with the power to levy taxes to pay it back, treasury debt is considered pretty much risk-free. An investment in treasury debt should be considered a long term investment that will help you preserve your capital and earn some interest. In the short term, the return of this investment may be affected by the Fed increasing interest rates – so use this as a long term component of your portfolio.
2. Public Works – an investment in municipal bonds.
Municipal bonds are debt securities issued by states, municipalities or counties to finance their capital expenditures, including day to day operations, and the construction of roads, highways, schools, hospitals, etc. Coupon payments from muni bonds are exempt from federal tax, so they are a fan-favorite among high-income tax brackets. Although each state has a different credit rating, all of the municipal bonds in this fund fall into the category of ‘investment grade’.
3. Park My Cash – an investment in short term corporate bonds. When a corporation wants to fund its day to day operations, it can issue new stock to shareholders or it can issue debt. Although slightly more risky than government debt, corporations in this investment are all ‘investment grade’, which means they’re considered creditworthy, not junk. They have a history of positive earnings, and can even borrow more money to pay back their previous obligations.
4. Conservative, Moderate, and Aggressive Mix – an investment in the broad US and international bond market.
All three of these mix investments have a little bit of everything. They are investments in stocks and bonds, and provide exposure to global markets as well. Each of these investments give you exposure to the broad US bond market, including a little bit of all of these kinds of debt mentioned above. These funds also give you exposure to international debt. And when you consider that the mixes also include international equity exposure, they are the kind of investments that should form the foundation of your Stash. What’s your mix?
You can find all of these investments in the I Want section of your Discover Tab. Looking for an investment to set on Auto-Stash? Turn it on for your mix level today.
Investing involves risk and investments may lose value. See our disclosures page for more information. *All credit ratings included above reference S&P credit ratings: Check Out The Table Here