Are unrated bonds more risky than rated bonds?

I am a sterling investor and have traditionally invested in well known sterling bond funds. These tend to include highly rated bonds such as AA and AAA, but the performance of these have been very disappointing this year. I am only interested in UK bond funds and wish to learn more about 'unrated bonds' and the risks attached to them.

One of the widely held misconceptions in bond markets is that unrated bonds are more risky than rated bonds. Such misconceptions can therefore be taken advantage of by prudent investors.

An unrated bond means that a credit agency has not attached a rating to it, e.g. BBB or AA. The absence of such a rating does not necessarily make the unrated bond more risky than a rated one.

In fact, unlike rated bonds, most unrated securities have secured characteristics, allowing the bond holder first legal charge on specified assets in the event of a default. Despite the fact these bonds offer better protection to the investor, they also usually offer enhanced yields in compensation for the lack of a rating.

A credit rating tells the investor the probability of a security defaulting, i.e. the future likelihood that the company will not be able to meet its obligation on a bond that it has issued.

The highest rating is AAA, which implies the default risk is at its lowest. Although credit ratings are important, they do not provide the investor with all the information needed to know whether a bond is fairly priced.

Even though they attempt to assess the probability of a security defaulting, they do not reveal the security's likely recovery rate, or take into account what changes could happen to the company in the future.

A recovery rate is the amount an investor gets back for every Lm100 nominal of a bond if it were to default. The recovery rate of a bond is very important since reducing the risk of capital losses is very important to long-term investors.

Approximately 10% of UK FTSE100 companies have unrated bonds issued. One of the reasons why issuers may choose not to rate their bonds is because bond ratings cost money. In the case of a small bond issue, many borrowers find it less expensive to pay a higher rate of interest to the investor than incur the cost of a bond rating.

Many of these unrated bonds have investment grade qualities and the right selection can prove fruitful to investors. By only buying bonds with a credit rating, an investor runs the risk of missing out on the unrated sector of the bond market, which offers higher-than-average yields.

I do not however suggest the average investor attempt to buy unrated bonds direct. Instead, these should be accessed via the appropriate fund where yields in sterling are in the region of 7%.

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 (office hours) or e-mail mh@hollingsworth-int.com.

Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.